x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED JULY 1, 2017

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE PERIOD FROM TO

Commission File Number 0-11559

____________________________________________________________

KEY TRONIC CORPORATION

(Exact name of registrant as specified in its charter)

____________________________________________________________

Washington

91-0849125

(State or other jurisdiction of

Incorporation or organization)

(I.R.S. Employer

Identification No.)

N. 4424 Sullivan Road, Spokane Valley,

Washington

99216

(Address of principal executive offices)

(Zip Code)

(509) 928-8000

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

____________________________________________________________

Securities Registered Pursuant to Section 12(b) of the Act: None

Title of each class

Name of each exchange on which registered

Common stock, no par value

The NASDAQ Stock Market LLC

Securities Registered Pursuant to Section 12(g) of the Act: None

____________________________________________________________

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

(Check one):

Large accelerated filer

¨

Accelerated filer

x

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company

¨

Emerging growth company

¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

State the aggregate market value of the voting and non-voting common equity held by non affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter.

As of December 31, 2016, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $79.8 million based on the closing price as reported on the NASDAQ.

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 10,759,680 shares of common stock were outstanding as of September 6, 2017.

____________________________________________________________

Documents Incorporated by Reference:

Certain information is incorporated into Part III of this report by reference to the Proxy Statement for the registrant's 2017 annual meeting of stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form 10-K.

References in this report to “the Company,” “Key Tronic,” “KeyTronicEMS,” “we,” “our,” or “us” mean Key Tronic Corporation together with its subsidiaries, except where the context otherwise requires.

This Annual Report on Form 10-K contains forward-looking statements in addition to historical information. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Risks and uncertainties that might cause such differences include, but are not limited to those outlined in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risks and Uncertainties that May Affect Future Results.” Readers are cautioned not to place undue reliance on forward-looking statements, which reflect management’s opinions only as of the date hereof. The Company undertakes no obligation to update forward-looking statements to reflect developments or information obtained after the date hereof and disclaims any obligation to do so. Readers should carefully review the risk factors described in periodic reports the Company files from time to time with the Securities and Exchange Commission, including Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.

PART I

Item 1.

BUSINESS

Background

Key Tronic Corporation (dba: KeyTronicEMS Co.) was organized in 1969, as a Washington corporation that locally manufactured computer keyboards. The ability to design, build and deliver a quality product led us to become a leading independent manufacturer of keyboards for computers in the United States. Our fully integrated design, tooling, and automated manufacturing capabilities enabled us to rapidly respond to customers’ needs for keyboards in production quantities worldwide. We supported our sales growth through the development and purchase of international manufacturing facilities. As the computer keyboard market matured with increasing competition from other international providers, we determined that our business could no longer solely rely on keyboard sales.

After assessing market conditions and our strengths and capabilities, we shifted our focus from keyboard manufacturing to contract manufacturing for a wide range of products. Our unique strategic attributes are based on our core strengths of innovative design and engineering expertise in electronics, mechanical engineering, sheet metal fabrication and stamping, and precision plastics combined with high-quality, low cost production, and assembly on an international basis while providing exceptional customer service. These strengths have made our company a strong competitor in the electronic manufacturing services (EMS) market.

Acquisition

On September 3, 2014, we completed the acquisition of all of the outstanding shares of CDR Manufacturing, Inc. (dba Ayrshire Electronics), which added five locations (four in North America and one in Mexico). This acquisition expanded our printed circuit board assembly capacity, total revenue, and added to and diversified our customer base with the addition of many new multi-national companies. Subsequent to the acquisition, the Reynosa, Mexico operations were transferred to the Company’s existing Juarez, Mexico facilities. During the second quarter of fiscal year 2017, we closed the Harrodsburg, Kentucky facility in order to improve operating efficiencies. The remaining programs from the Kentucky facility have been transferred to other Key Tronic facilities.

Our Industry and Strategy

The expansion of the EMS industry and our acquisitions have allowed us to continue to expand our customer base and the industries that we serve. The increase in new programs represents a growing portion of our revenue and a promising foundation for our future. In keeping with our long-term strategic objectives, we have been successfully building a more diversified customer portfolio, spanning a wider range of industries. We currently offer our customers the following services: integrated electronic and mechanical engineering, precision plastic molding, sheet metal fabrication, printed circuit board (PCB) and complete product assembly, component selection, sourcing and procurement, worldwide logistics, and new product testing and production all at competitive pricing due to our global footprint. We differentiate ourselves from others our size and larger in the EMS industry by providing vertical integration, a flexible and responsive approach to our customer’s changing supply demand, and complete design engineering support.

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We believe that we are well positioned in the EMS industry to continue the expansion of our customer base and achieve long term growth. Our unique blend of multinational facilities, vertical integration, centralized management, and core strengths continue to support our growth and our customers’ needs. We continue to focus on controlling operating expenses and leveraging the synergistic capabilities of our world-class facilities in the United States, Mexico, and China. This international production capability provides our customers with the benefits of improved supply-chain management, reduced inventory, lower labor costs, lower transportation costs, and reduced product fulfillment time. Given our competitive advantages and the growing pressure for new potential customers to move forward with their outsourcing strategies, we are strongly positioned to win new business in coming periods and grow our revenue and profits.

The EMS industry is intensely competitive. Although our customer base is growing, we still have less than 1% of the potential global market and our revenue can fluctuate significantly due to reliance on a concentrated base of customers. We are planning for new customer growth in the coming quarters by securing new programs with new and existing customers, increasing our worldwide manufacturing capacity, leveraging further our design engineering capabilities and continuing to improve our manufacturing and procurement processes. Ongoing challenges that we face include but are not limited to the following: Continuing to win programs from new and existing customers, balancing capital employed, production capacity and key personnel in support of new customer programs, improving operating efficiencies, controlling costs while developing competitive pricing strategies, and successfully transitioning new program wins to full production.

Sales of the majority of our products have not historically been seasonal in nature, but may be seasonal in the future if there are changes in the types of products manufactured. Sales can, however, fluctuate significantly between quarters from changes in customers and customer demand due to the concentration of sales generated by our largest customers.

For the fiscal years 2017, 2016 and 2015, the five largest customers in each year accounted for 42%, 41% and 42% of combined total net sales, respectively. We continue to diversify our customer base by adding additional programs and customers. We expect net sales to our five largest customers as a percentage of total net sales to approximate current levels going forward.

The following table represents all customers that represented 10% or more of total net sales during the last three fiscal years:

Percentage of Net Sales by Fiscal Year

2017

2016

2015

Customer A

18%

18%

17%

There can be no assurance that the Company’s principal customers will continue to purchase products from the Company at current levels. Moreover, the Company typically does not enter into long-term volume purchase contracts with its customers, and the Company’s customers have certain rights to extend or delay the shipment of their orders. The loss of one or more of the Company’s major customers, or the reduction, delay or cancellation of orders from such customers, could materially and adversely affect the Company’s business, operating results and financial condition.

We market our products and services primarily through our direct sales department which is comprised of strategically located field sales people and distributors. We also maintain relationships with several independent sales organizations to assist in marketing our EMS product lines.

Manufacturing

We have continually made investments in developing and expanding a capital equipment base to achieve vertical integration and efficiencies in our manufacturing processes. We have invested significant capital into SMT for volume manufacturing of complex printed circuit board assemblies and in our metal shop providing precision metal stamping, fabricating, and finishing. We also design and develop tooling for injection molding and sheet metal fabrication and manufacture the majority of plastic and sheet metal parts used in the products we manufacture. Additionally, we have equipment to maintain a controlled clean environment for manufacturing processes that require a high level of precise control.

Our engineering expertise and automated manufacturing processes enable us to work closely with our customers during the design and prototype stages of production and to jointly increase productivity and reduce response time to the marketplace. We use computer-aided design techniques and software to assist in preparation of the tool design layout and component placement, to reduce tooling and production costs, improve component and product quality, and enhance turnaround time during product development.

We purchase materials and components for our products from many different suppliers, including both domestic and international sources. We develop close working relationships with our suppliers, many of whom have been supplying products to us for several years.

Research, Development, and Engineering

As part of our long-term strategy, we are committed to supporting our customers by providing research, development, and engineering services. We have recently seen an increase in the success of providing design support on existing and potential customers in differentiating ourselves. These services allow us to facilitate in optimizing new product designs, and the production processes of our customers' programs.

The market for the products and services we provide is highly competitive. There are numerous competitors in the EMS industry, many of which have substantially more resources and are more geographically diverse than we are. Some of our competitors have similar international production capabilities, large financial resources and some have substantially greater manufacturing, research and development, and marketing resources. There is also competition from the manufacturing operations of our current and potential customers, who are continually evaluating the merits of manufacturing their products internally versus the advantages of outsourcing. We believe that we can currently compete favorably in these areas primarily on the basis of our international footprint, responsiveness, creativity, vertical production capability, quality, and cost.

Trademarks

Our name and logo are federally registered trademarks, and we believe they are valuable assets of our business. We operate under the trade name “KeyTronicEMS” to better identify our primary business concentration in contract manufacturing in the EMS industry.

Employees

We consider our employees to be our primary strength and we make considerable efforts to maintain a well-qualified workforce. Our employee benefits include bonus programs involving periodic payments to all employees based on meeting quarterly or fiscal year performance targets. We regularly provide transportation, medical services, and meals to all of our employees in foreign locations. The Company also has defined contribution plans available to U.S. employees who have attained age 21 and provide group health, life, and disability insurance plans. We also maintain share based compensation plans and other long term incentive plans for certain employees and outside directors.

As of July 1, 2017 we had 5,038 full-time employees compared to 4,947 on July 2, 2016, and 4,866 on June 27, 2015. Since we can have significant fluctuations in product demand, we seek to maintain flexibility in our workforce by utilizing skilled temporary and short-term contract labor in our manufacturing facilities in addition to full-time employees.

Backlog

On July 29, 2017 our order backlog was valued at approximately $126.9 million, compared to approximately $122.2 million on July 30, 2016. The amount of backlog is not necessarily indicative of future sales but can be indicative of trends in expected future sales revenue. Due to the relationships with our customers, we will occasionally allow orders to be canceled or rescheduled and as a result it is not a meaningful indicator of future financial results. If there are canceled or rescheduled orders, we typically negotiate fees to cover the costs we have incurred. Order backlog consists of purchase orders received for products expected to be shipped approximately within the next twelve months, although shipment dates are subject to change due to design modifications, customer forecast changes, or other customer requirements.

Foreign Markets

Information concerning net sales and long-lived assets (property, plant, and equipment) by geographic areas is set forth in Note 12, “Enterprise-Wide Disclosures” of the consolidated financial statements of this Annual Report on Form 10-K and that information is incorporated herein.

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Executive Officers of the Registrant

The table below sets forth the name, current age and current position of our executive officers and other significant employees:

Name

Age

Positions Held

Executive Officers

Craig D. Gates

58

President and Chief Executive Officer

Brett R. Larsen

44

Executive Vice President of Administration, Chief Financial Officer, and Treasurer

Douglas G. Burkhardt

59

Executive Vice President of Worldwide Operations

Philip S. Hochberg

55

Executive Vice President of Business Development

Lawrence J. Bostwick

65

Vice President of Regulatory Affairs

David H. Knaggs

36

Vice President of Quality

Frank Crispigna III

56

Vice President of Materials

Duane D. Mackleit

49

Vice President of Program Management

Chad T. Orebaugh

46

Vice President of Engineering

Executive Officers

CRAIG D. GATES – President and Chief Executive Officer

Mr. Gates, age 58, has been President and Chief Executive officer of the Company since April 2009. Previously, he was Executive Vice President and General Manager from August 2002 to April 2009. He served as Executive Vice President of Marketing, Engineering and Sales from July 1997 to August 2002 and served as Vice President and General Manager of New Business Development from October 1995 to July 1997. He joined the Company as Vice President of Engineering in October of 1994. From 1982 to 1991 he held various engineering and management positions within the Microswitch Division of Honeywell, Inc., in Freeport, Illinois, and from 1991 to October 1994 he served as Director of Operations, Electronics for Microswitch. Mr. Gates has a Bachelor of Science Degree in Mechanical Engineering and a Masters in Business Administration from the University of Illinois, Urbana.

Mr. Larsen, age 44, has served as Executive Vice President of Administration, Chief Financial Officer, and Treasurer since July 2015. Previously, he was Vice President of Finance and Controller from February 2010 to July 2015. He was Chief Financial Officer of FLSmidth Spokane, Inc. from December 2008 to February 2010. From October 2005 through November 2008, Mr. Larsen served as Controller of Key Tronic Corporation. From May 2004 to October 2005, Mr. Larsen served as Manager of Financial Reporting of Key Tronic Corporation. From 2002 to May 2004, Mr. Larsen was an audit manager for the public accounting firm BDO USA, LLP. He also held various auditing and supervisory positions with Grant Thornton LLP from 1997 to 2002. Mr. Larsen has a Bachelor of Science degree in Accounting and a Masters degree in Accounting from Brigham Young University and is a Certified Public Accountant.

Mr. Burkhardt, age 59, has been Executive Vice President of Worldwide Operations of the Company since July 2010. Previously Mr. Burkhardt was Vice President of Worldwide Operations from July 2008 to July 2010 and Director of China Operations and Program Management from January 2006 to July 2008. Mr. Burkhardt also served as Director of Northwest and China Operations from November of 1998 to January of 2006. Mr. Burkhardt also served as Director of Customer Satisfaction from March 1997 to November 1998 and Director of Molding from September of 1995 to March of 1997. Prior to this, Mr. Burkhardt served in other various senior management positions within the Company. Mr. Burkhardt has been with the Company since May of 1989. Prior to joining Key Tronic, Mr. Burkhardt worked for House of Aluminum and Glass for 12 years where he was the plant manager.

PHILIP S. HOCHBERG – Executive Vice President of Business Development

Mr. Hochberg, age 55, has been Executive Vice President of Business Development since July 2012. Prior to this, Mr. Hochberg served as Vice President of Business Development from October 2009 through June 2012. He was Director of Business Development and Program Management from July 2008 to October 2009. Mr. Hochberg served as Director of Business Development from October 2004 to July 2008 and as Director of EMS Sales and Marketing from July 2000 to October 2004. Prior to joining Key Tronic, Mr. Hochberg worked for Quinton Instrument Company as their Director of Marketing and Product Management from 1992 to 2000. From 1988 to 1992, he was employed by SpaceLabs Medical as their Business Development Marketing Manager. Mr. Hochberg has an MBA from the University of British Columbia, a BA in Psychology, with a minor in Business from Washington University in St. Louis.

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LAWRENCE J. BOSTWICK – Vice President of Regulatory Affairs

Mr. Bostwick, age 65, has been Vice President of Engineering and Quality since July 2008. Previously he was Director of Engineering and Quality from February 2007 to July 2008 and served as Corporate Director of Quality from February 2006 to February 2007. From 2003 to 2006 he was Director of Supply Chain Management and Quality for the Lancer Corporation and from 1998 to 2003 he was Vice President of Operations for Thermacore International. He is a graduate of the Westinghouse and General Electric – Engineering and Manufacturing Professional Development Programs. He is certified in both Quality and Industrial Engineering and is a Lean – Six Sigma Master Black Belt. Mr. Bostwick has a combined B.S. degree in Production and Operation and Industrial Engineering from Bowling Green State University and a Masters degree in Industrial Engineering and Business Administration from Syracuse University.

DAVID H. KNAGGS – Vice President of Quality

Mr. Knaggs, age 36, has been Vice President of Quality of the company since October 2016. Before joining KeyTronicEMS, Mr. Knaggs worked at Telect, Inc. from 2008 to 2016 as their Director of Engineering. Prior to that, he worked at Isothermal Systems Research as Lead Systems Engineer from 2003 to 2008. He has a Bachelor of Science degree in Mechanical Engineering with a minor in mathematics from the University of Washington.

FRANK CRISPIGNA III – Vice President of Materials

Mr. Crispigna, age 56, has been Vice President of Materials of the company since October 2011. Prior to this, Mr. Crispigna held a variety of Materials and Supply Chain positions at Plexus Corporation since 1997, most recently serving as the Director – Supply Chain Solutions from 2005 - 2011. He has a Masters degree in Business Administration, and a Bachelor of Business Administration Degree in Marketing from the University of Wisconsin – Oshkosh. Mr. Crispigna also is a C.P.M., and received his certification in Supply Chain Leadership from the University of Wisconsin.

DUANE D. MACKLEIT – Vice President of Program Management

Mr. Mackleit, age 49, has been Vice President of Program Management of the company since July 2012. He served as Director of Program Management from July 2008 through June 2012. From May 2006 to July 2008 he served as Principal Program Manager. Prior to that, he served as Program Manager from March 2002 to May 2006 and Associate Program Manager from August 2000 to March 2002. Mr. Mackleit has also held several other positions with Key Tronic Corporation. Mr. Mackleit has an AA in Business from Spokane Falls Community College and a BA in Business/Marketing from Eastern Washington University. He also holds a MBA from Gonzaga University.

CHAD T. OREBAUGH – Vice President of Engineering

Mr. Orebaugh, age 46, has been Vice President of Engineering since April 2017. Prior to this, Mr. Orebaugh served as Director of Engineering since May 2013. From April 2010 to May 2013, he served as Manager of Engineering. From January 2000 to April 2010 he served as Lead Mechanical Engineer. Prior to that, he served as Mechanical Engineer from October 1998 to January 2000 and Associate Mechanical Engineer since October 1997. Mr. Orebaugh holds a BA in Mechanical Engineering from Gonzaga University.

Available Information

Our principal executive offices are located at 4424 North Sullivan Road, Spokane Valley, Washington 99216, and our telephone number is (509) 928-8000. Our website is located at http://www.keytronic.com where filings of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q or current reports on Form 8-K are available after they have been filed with the Securities and Exchange Commission. The information presented on our website currently and in the future is not considered to be part of this document or any document incorporated by reference in this document.

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Item 1A.

RISK FACTORS

There are risks and uncertainties that could affect our business. These risks and uncertainties include but are not limited to, the risk factors described below, in Item 7A: “Quantitative and Qualitative Disclosures about Market Risk” and elsewhere in this Form 10-K.

RISKS AND UNCERTAINTIES THAT MAY AFFECT FUTURE RESULTS

The following risks and uncertainties could affect our actual results and could cause results to differ materially from past results or those contemplated by our forward-looking statements. When used herein, the words “expects,” “believes,” “anticipates” and other similar expressions are intended to identify forward-looking statements.

We may experience fluctuations in quarterly results of operations.

Our quarterly operating results have varied in the past and may vary in the future due to a variety of factors, including adverse changes in the U.S. and global macroeconomic environment, volatility in overall demand for our customers’ products, success of customers’ programs, timing of new programs, new product introductions or technological advances by us, our customers and our competitors, and changes in pricing policies by us, our customers, our suppliers, and our competitors. Our customer base is diverse in the markets they serve, however, decreases in demand, particularly from customers in certain industries could affect future quarterly results. Additionally, our customers could be adversely impacted by illiquidity in the credit markets which could directly impact our operating results.

Component procurement, production schedules, personnel and other resource requirements are based on estimates of customer requirements. Occasionally, our customers may request accelerated production that can stress resources and reduce operating margins. Conversely, our customers may abruptly lower or cancel production which may lead to a sudden, unexpected increase in inventory or accounts receivable for which we may not be reimbursed even when under contract with customers. In addition, because many of our operating expenses are relatively fixed, a reduction in customer demand can harm our gross profit and operating results. The products which we manufacture for our customers have relatively short product lifecycles. Therefore, our business, operating results and financial condition are dependent in a significant way on our ability to obtain orders from new customers and new product programs from existing customers.

Operating results can also fluctuate if changes are made to significant estimates and assumptions. Significant estimates and assumptions include the allowance for doubtful receivables, provision for obsolete and non-saleable inventory, stock-based compensation, the valuation allowance on deferred tax assets, valuation of goodwill, impairment of long-lived assets, long-term incentive compensation accrual, the provision for warranty costs, the impact of hedging activities and purchase price allocation.

We are exposed to general economic conditions, which could have a material adverse impact on our business, operating results and financial condition.

Adverse economic conditions and uncertainty in the global economy such as unstable global financial and credit markets, inflation, and recession can negatively impact our business. Unfavorable economic conditions could affect the demand for our customers’ products by triggering a reduction in orders as well as a decline in forecasts which could adversely affect our sales in future periods. Additionally, the financial strength of our customers and suppliers and their ability to obtain and rely on credit financing may affect their ability to fulfill their obligations to us and have an adverse effect on our financial results.

The majority of our sales come from a small number of customers and a decline in sales to any of these customers could adversely affect our business.

At present, our customer base is concentrated and could become more or less concentrated. There can be no assurance that our principal customers will continue to purchase products from us at current levels. Moreover, we typically do not enter into long-term volume purchase contracts with our customers, and our customers have certain rights to extend or delay the shipment of their orders. We, however, typically require that our customers contractually agree to buy back inventory purchased within specified lead times to build their products if not used.

The loss of one or more of our major customers, or the reduction, delay or cancellation of orders from such customers, due to economic conditions or other forces, could materially and adversely affect our business, operating results and financial condition. The contraction in demand from certain industries could impact our customer orders and have a negative impact on our operations over the foreseeable future. Additionally, if one or more of our customers were to become insolvent or otherwise unable to pay for the manufacturing services provided by us, our operating results and financial condition would be adversely affected.

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We depend on a limited number of suppliers for certain components that are critical to our manufacturing processes. A shortage of these components or an increase in their price could interrupt our operations and result in a significant change in our results of operations.

We are dependent on many suppliers, including sole source suppliers, to provide key components and raw materials used in manufacturing customers’ products. We have seen supply shortages in certain electronic components. In addition, our suppliers' facilities may also experience earthquakes, tsunamis and other natural disasters which may cause a shortage of components. This can result in longer lead times and the inability to meet our customers request for flexible production and extended shipment dates. If demand for components outpaces supply, capacity delays could affect future operations. Delays in deliveries from suppliers or the inability to obtain sufficient quantities of components and raw materials could cause delays or reductions in shipment of products to our customers which could adversely affect our operating results and damage customer relationships.

We operate in a highly competitive industry; if we are not able to compete effectively in the EMS industry, our business could be adversely affected.

Competitors may offer customers lower prices on certain high volume programs. This could result in price reductions, reduced margins and loss of market share, all of which would materially and adversely affect our business, operating results, and financial condition. If we were unable to provide comparable or better manufacturing services at a lower cost than our competitors, it could cause sales to decline. In addition, competitors can copy our non-proprietary designs and processes after we have invested in development of products for customers, thereby enabling such competitors to offer lower prices on such products due to savings in development costs.

Cash and cash equivalents are exposed to concentrations of credit risk.

We place our cash with high credit quality institutions. At times, such balances may be in excess of the federal depository insurance limit or may be on deposit at institutions which are not covered by insurance. If such institutions were to become insolvent during which time it held our cash and cash equivalents in excess of the insurance limit, it could be necessary to obtain other credit financing to operate our facilities.

Our ability to secure and maintain sufficient credit arrangements is key to our continued operations.

There is no assurance that we will be able to retain or renew our credit agreements in the future. In the event the business grows rapidly or there is uncertainty in the macroeconomic climate, additional financing resources could be necessary in the current or future fiscal years. There is no assurance that we will be able to obtain equity or debt financing at acceptable terms, or at all in the future. In addition, we have restrictive covenants with our financial institution which could impact how we manage our business. If we cannot meet our financial covenants, our borrowings could become immediately payable which could have a material adverse impact on our financial statements. For a summary of our banking arrangements, see Note 4 Long-Term Debt of the “Notes to Consolidated Financial Statements.”

Our operations may be subject to certain risks.

We manufacture product in facilities located in Mexico, China and the United States. These operations may be subject to a number of risks, including:

•

difficulties in staffing, turnover and managing onshore and offshore operations;

•

political and economic instability (including acts of terrorism, pandemics, civil unrest, forms of violence and outbreaks of war), which could impact our ability to ship, manufacture, and/or receive product;

Our operations in certain foreign locations receive favorable income tax treatment in the form of tax credits or other incentives. In the event that such tax incentives are not extended, are repealed, or we no longer qualify for such programs, our taxes may increase, which would reduce our net income.

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Additionally, certain foreign jurisdictions restrict the amount of cash that can be transferred to the U.S or impose taxes and penalties on such transfers of cash. To the extent we have excess cash in foreign locations that could be used in, or is needed by, our operations in the United States, we may incur significant penalties and/or taxes to repatriate these funds.

We have manufacturing operations located in Mexico and China. A significant portion of our operations are denominated in the Mexican peso and the Chinese currency, the renminbi ("RMB"). Currency exchange rates fluctuate daily as a result of a number of factors, including changes in a country's political and economic policies. Volatility in the currencies of our entities and the United States dollar could seriously harm our business, operating results and financial condition. The primary impact of currency exchange fluctuations is on the cash, receivables, payables and expenses of our operating entities. As part of our hedging strategy, we currently use Mexican peso forward contracts to hedge foreign currency fluctuations for a portion of our Mexican peso denominated expenses. We currently do not hedge expenses denominated in RMB. Unexpected losses could occur from increases in the value of these currencies relative to the United States dollar.

Our success will continue to depend to a significant extent on our key personnel.

Our future success depends in large part on the continued service of our key technical, marketing and management personnel and on our ability to continue to attract and retain qualified production employees. There can be no assurance that we will be successful in attracting and retaining such personnel, particularly in our manufacturing locales that may be experiencing high demand for similar key personnel. The loss of key employees could have a material adverse effect on our business, operating results and financial condition.

If we are unable to maintain our technological and manufacturing process expertise, our business could be adversely affected.

The markets for our customers’ products is characterized by rapidly changing technology, evolving industry standards, frequent new product introductions and short product life cycles. The introduction of products embodying new technologies or the emergence of new industry standards can render existing products obsolete or unmarketable. Our success will depend upon our customers’ ability to enhance existing products and to develop and introduce, on a timely and cost-effective basis, new products that keep pace with technological developments and emerging industry standards and address evolving and increasingly sophisticated customer requirements. Failure of our customers to do so could substantially harm our customers’ competitive positions. There can be no assurance that our customers will be successful in identifying, developing and marketing products that respond to technological change, emerging industry standards or evolving customer requirements.

Start-up costs and inefficiencies related to new or transferred programs can adversely affect our operating results and such costs may not be recoverable if such new programs or transferred programs are canceled or don’t meet expected sales volumes.

Start-up costs, the management of labor and equipment resources in connection with the establishment of new programs and new customer relationships, and the need to obtain required resources in advance can adversely affect our gross margins and operating results. These factors are particularly evident in the ramping stages of new programs. These factors also affect our ability to efficiently use labor and equipment. We are currently managing a number of new programs. Consequently, our exposure to these factors has increased. In addition, if any of these new programs or new customer relationships were terminated, our operating results could be harmed, particularly in the short term. We may not be able to recoup these start-up costs or replace anticipated new program revenues.

Customers may change production timing and demand schedules which makes it difficult for us to schedule production and capital expenditures and to maximize the efficiency of our manufacturing capacity.

Changes in demand for customer products reduce our ability to accurately estimate the future requirements of our customers. This makes it difficult to schedule production and maximize utilization of our manufacturing capacity. We must determine the levels of business that we will seek and accept from customers, set production schedules, commit to procuring inventory, and allocate personnel and resources, based on our estimates of our customers' requirements. Customers can require sudden increases and decreases in production which can put added stress on resources and reduce margins. Sudden decreases in production can lead to excess inventory on hand which may or may not be reimbursed by our customers even when under contract.

Continued growth could further lead to capacity constraints. We may need to transfer production to other facilities, acquire new facilities, or outsource production which could negatively impact gross margin.

11

An adverse change in the interest rates for our borrowings could adversely affect our financial condition.

We are exposed to interest rate risk under our revolving line of credit and term loan. We currently hedge a portion of our term loan with an interest rate swap. We have not historically hedged the interest rate on our credit facility; therefore, unless we do so, significant changes in interest rates could adversely affect our results of operations. Refer to the discussion in note 4, "Long-Term Debt" to the consolidated financial statements for further details of our debt obligations. We are also exposed to interest rate risk on our factoring activities.

Compliance or the failure to comply with current and future environmental laws or regulations could cause us significant expense.

We are subject to a variety of domestic and foreign environmental regulations relating to the use, storage, and disposal of materials used in our manufacturing processes. If we fail to comply with any present or future regulations, we could be subject to future liabilities or the suspension of current manufacturing operations. In addition, such regulations could restrict our ability to expand our operations or could require us to acquire costly equipment, substitute materials, or incur other significant expenses to comply with government regulations.

Our stock price is volatile.

Holders of the common stock will suffer immediate dilution to the extent outstanding equity awards are exercised to purchase common stock. Our stock price may be subject to wide fluctuations and possible rapid increases or declines over a short time period. These fluctuations may be due to factors specific to us such as our stock's thinly traded nature, variations in quarterly operating results or changes in earnings estimates, or to factors relating to the EMS industry or to the securities markets in general, which, in recent years, have experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stocks are traded.

Due to inherent limitations, there can be no assurance that our system of disclosure and internal controls and procedures will be successful in preventing all errors, theft and fraud, or in informing management of all material information in a timely manner.

Management does not expect that our disclosure controls and internal controls and procedures will prevent all errors or fraud. A control system is designed to give reasonable, but not absolute, assurance that the objectives of the control system are met. In addition, any control system reflects resource constraints and the benefits of controls must be considered relative to their costs. Inherent limitations of a control system may include: judgments in decision making may be faulty, breakdowns can occur simply because of error or mistake and controls can be circumvented by collusion or management override. Due to the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.

If we do not manage our growth effectively, our profitability could decline.

Our business is experiencing growth which can place considerable additional demands upon our management team and our operational, financial and management information systems. Our ability to manage growth effectively requires us to continue to implement and improve these systems; avoid cost overruns; maintain customer, supplier and other favorable business relationships during possible transition periods; continue to develop the management skills of our managers and supervisors; and continue to train, motivate and manage our employees. Our failure to effectively manage growth could have a material adverse effect on our results of operations.

12

If our manufacturing processes and services do not comply with applicable statutory and regulatory requirements, or if we manufacture products containing design or manufacturing defects, demand for our services may decline and we may be subject to liability claims.

We manufacture and design products to our customers’ specifications, and, in some cases, our manufacturing processes and facilities may need to comply with applicable statutory and regulatory requirements. For example, medical devices that we manufacture or design, as well as the facilities and manufacturing processes that we use to produce them, are regulated by the Food and Drug Administration and non-U.S. counterparts of this agency. In addition, our customers’ products and the manufacturing processes that we use to produce them often are highly complex. As a result, products that we manufacture may at times contain manufacturing or design defects, and our manufacturing processes may be subject to errors or not be in compliance with applicable statutory and regulatory requirements. Defects in the products we manufacture or design, whether caused by a design, manufacturing or component failure or error, or deficiencies in our manufacturing processes, may result in delayed shipments to customers or reduced or canceled customer orders. If these defects or deficiencies are significant, our business reputation may also be damaged. The failure of the products that we manufacture or our manufacturing processes and facilities to comply with applicable statutory and regulatory requirements may subject us to legal fines or penalties and, in some cases, require us to shut down or incur considerable expense to correct a manufacturing process or facility. Our customers are required to indemnify us against liability associated with designing products to meet their specifications. However, if our customers are responsible for the defects, they may not, or may not have resources to, assume responsibility for any costs or liabilities arising from these defects, which could expose us to additional liability claims.

Certain components that we use in our manufacturing process are petroleum-based. In addition, we, along with our suppliers and customers, rely on various energy sources in our transportation activities. While significant uncertainty currently exists about the future levels of energy prices, a significant increase is possible. Increased energy prices could cause an increase to our raw material costs and transportation costs. In addition, increased transportation costs of certain of our suppliers and customers could be passed along to us. We may not be able to increase our product prices enough to offset these increased costs. In addition, any increase in our product prices may reduce our future customer orders and profitability.

We rely on information technology networks and systems to process, transmit and store electronic information. In particular, we depend on our information technology infrastructure for a variety of functions, including worldwide financial reporting, inventory management, procurement, invoicing and email communications. Any of these systems may be susceptible to outages due to fire, floods, power loss, telecommunications failures, terrorist attacks and similar events. Despite the implementation of network security measures, our systems and those of third parties on which we rely may also be vulnerable to computer viruses, break-ins and similar disruptions. If we or our vendors are unable to prevent such outages and breaches, our operations could be disrupted.

We are involved in various legal proceedings.

In the past, we have been notified of claims relating to various matters including contractual matters, intellectual property rights or other issues arising in the ordinary course of business. In the event of such a claim, we may be required to spend a significant amount of money to defend or otherwise address the claim. The Company is currently involved in an arbitration claim with a former customer to collect a significant payment for excess inventory purchased to an existing manufacturing agreement in place at the time. Any litigation or dispute resolution, even where a claim is without merit, could result in substantial costs and diversion of resources. Accordingly, the resolution or adjudication of such disputes, even those encountered in the ordinary course of business, could have a material adverse effect on our business, consolidated financial conditions and results of operations.

Our levels of insurance coverage may not be sufficient for potential damages, claims or losses.

We have various forms of business and liability insurance which we believe are appropriate based on the needs of companies in our industry. As a result, not all of our potential business risks or potential losses would be covered by our insurance policies. If we sustain a significant claim or loss which is not covered by insurance, our net income could be negatively impacted.

13

Changes in securities laws and regulations will increase our costs and risk of noncompliance.

We are required to file as an accelerated filer. As such, we are subject to additional requirements contained in the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act) and more recently the Dodd-Frank Act. The Sarbanes-Oxley and Dodd-Frank Acts required or will require changes in some of our corporate governance, securities disclosure and compliance practices. In response to the requirements of the Sarbanes-Oxley and Dodd-Frank Acts, the SEC and NASDAQ promulgated new rules and additional rulemaking is expected in the future. Compliance with these new rules and future rules has increased and may increase further our legal, financial and accounting costs as well as a potential risk of noncompliance. Absent significant changes in related rules, which we cannot assure, we anticipate some level of increased costs related to these new regulations to continue indefinitely. We also expect these developments to make it more difficult and more expensive to obtain director and officer liability insurance, and we may be forced to accept reduced coverage or incur substantially higher costs to obtain coverage. Likewise, these developments may make it more difficult for us to attract and retain qualified members of our Board of Directors or qualified management personnel. Further, the costs associated with the compliance with and implementation of procedures under these and future laws and related rules could have a material impact on our results of operations. In addition, the costs associated with noncompliance with additional securities laws and regulations could also impact our business.

We may encounter complications with acquisitions, which could potentially harm our business.

Any current or future acquisitions may require additional equity financing, which could be dilutive to our existing shareholders, or additional debt financing, which could potentially affect our credit ratings. Any downgrades in our credit ratings associated with an acquisition could adversely affect our ability to borrow by resulting in more restrictive borrowing terms. To integrate acquired businesses, we must implement our management information systems, operating systems and internal controls, and assimilate and manage the personnel of the acquired operations. The integration of acquired businesses may be further complicated by difficulties managing operations in geographically dispersed locations. The integration of acquired businesses may not be successful and could result in disruption by diverting management’s attention from the core business. In addition, the integration of acquired businesses may require that we incur significant restructuring charges or other increases in our expenses and working capital requirements, which reduce our return on invested capital.

Acquisitions may involve numerous other risks and challenges including but not limited to: potential loss of key employees and customers of the acquired companies; the potential for deficiencies in internal controls at acquired companies; lack of experience operating in the geographic market or industry sector of the acquired business; constraints on available liquidity, and exposure to unanticipated liabilities of acquired companies. These and other factors could harm our ability to achieve anticipated levels of profitability at acquired operations or realize other anticipated benefits of an acquisition, and could adversely affect our consolidated business and operating results.

Our goodwill and identifiable intangible assets could become impaired, which could reduce the value of our assets and reduce net income in the year in which the write-off occurs.

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. The Company also ascribes value to certain identifiable intangible assets, which consists of customer relationships, non-compete agreements, and favorable leases, as a result of the acquisitions of Sabre and Ayrshire. The Company may incur impairment charges on goodwill or identifiable intangible assets if it determines that the fair values of goodwill or identifiable intangible assets are less than their current carrying values. The Company evaluates, on a regular basis, whether events or circumstances have occurred that indicate all, or a portion, of the carrying amount of goodwill may no longer be recoverable, in which case an impairment charge to earnings would become necessary.

Refer to Notes 1 and 15 to the consolidated financial statements and critical accounting policies and estimates' in management’s discussion and analysis of financial condition and results of operations for further discussion regarding the impairment testing of goodwill and identifiable intangible assets.

A decline in general economic conditions or global equity valuations could impact the judgments and assumptions about the fair value of the Company’s businesses and the Company could be required to record impairment charges on its goodwill or other identifiable intangible assets in the future, which could impact the Company’s consolidated balance sheet, as well as the Company’s consolidated statement of operations. If the Company was required to recognize an impairment charge in the future, the charge would not impact the Company's consolidated cash flows, current liquidity, capital resources, and covenants under its existing credit facilities.

14

Changes in financial accounting standards may affect our reported financial condition or results of operations as well increase costs related to implementation of new standards and modifications to internal controls.

Our consolidated financial statements are prepared in conformity with accounting standards generally accepted in the United States, or U.S. GAAP. These principles are subject to amendments made primarily by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions which are completed before a change is announced. For example, significant changes to revenue recognition rules will be effective for us in fiscal 2019 and we may incur significant costs to implement this new rule. Changes to accounting rules or challenges to our interpretation or application of the rules by regulators may have a material adverse effect on our reported financial results or on the way we conduct business. In addition, the continued convergence of U.S. GAAP and International Financial Reporting Standards ("IFRS") creates uncertainty as to the financial accounting policies and practices we will need to adopt in the future.

Item 1B.

UNRESOLVED STAFF COMMENTS

None

Item 2.

PROPERTIES AS OF DATE OF FILING

We have manufacturing and sales operations located in the United States, Mexico, and China. The table below lists the locations and square footage of our operating facilities:

Location

Approx.Sq. Ft.

Type of Interest(Leased/Owned)

Description of Use

Corinth, Mississippi

350,000

Leased

Manufacturing and warehouse

El Paso, Texas

80,000

Leased

Shipping and warehouse

Fayetteville, Arkansas

175,000

Leased

Manufacturing and warehouse

Harrodsburg, Kentucky (1)

22,000

Owned

Manufacturing and warehouse

Louisville, Kentucky

2,000

Leased

Administration

Oakdale, Minnesota

60,000

Leased

Manufacturing and warehouse

Spokane Valley, Washington

95,000

Leased

Sales, research, administration and manufacturing

Spokane Valley, Washington

36,000

Leased

Manufacturing

Total USA

820,000

Juarez, Mexico

193,000

Leased

Warehouse

Juarez, Mexico

174,000

Owned

Manufacturing

Juarez, Mexico

115,000

Owned

Manufacturing and warehouse

Juarez, Mexico

103,000

Owned

Manufacturing and warehouse

Juarez, Mexico

72,000

Leased

Manufacturing

Juarez, Mexico

66,000

Owned

Manufacturing and warehouse

Juarez, Mexico

60,000

Owned

Manufacturing and warehouse

Total Mexico

783,000

Shanghai, China

121,000

Leased

Manufacturing and warehouse

Shanghai, China

36,000

Leased

Manufacturing

Total China

157,000

Grand Total

1,760,000

(1)

During fiscal year 2017, we closed the Harrodsburg, Kentucky location and transferred customer programs to other facilities in the USA. The facility is currently listed for sale. Additionally, the property is not yet actively marketed and sale of the building in less than one year is not probable at this time. As such, the property is appropriately being reported in Property, Plant, and Equipment.

The geographic diversity of these locations allows us to offer services near certain of our customers and major electronics markets with the additional benefit of reduced labor costs. We consider the productive capacity of our current facilities sufficient to carry on our current business. In addition, in Juarez, Mexico one of our buildings includes adjacent vacant land that could be developed into additional manufacturing and warehouse space.

We are a party to certain lawsuits or claims in the ordinary course of business. We do not believe that these proceedings, individually or in the aggregate, will have a material adverse effect on our financial position, results of operations or cash flow. Refer to Commitment and Contingencies footnote for further details on litigation in the fiscal year.

Our common stock is traded on the NASDAQ Global Market, formerly the NASDAQ National Market System under the symbol “KTCC.” Quarterly high and low sales prices for our common stock for fiscal years 2017 and 2016 were as follows:

2017

2016

High

Low

High

Low

First Quarter

$

8.28

$

7.23

$

11.15

$

9.75

Second Quarter

8.18

7.08

10.39

7.50

Third Quarter

8.20

7.08

8.47

6.09

Fourth Quarter

8.00

6.69

8.97

6.99

High and low stock prices are based on the daily sales prices reported by the NASDAQ Stock Market. These quotations represent prices between dealers without adjustment for markups, markdowns, and commissions, and may not represent actual transactions.

Holders and Dividends

As of July 1, 2017, we had 688 shareholders of common stock on record. As a result of our credit agreement with Wells Fargo Bank, N.A. we are restricted from declaring or paying dividends in cash or stock without the Bank’s prior written consent. We have not paid a cash dividend and do not anticipate payment of dividends in the foreseeable future.

Equity Compensation Plan Information

Information concerning securities authorized for issuance under our equity compensation plans is set forth in Part III, Item 12 of this Annual Report, under the caption “Securities Authorized for Issuance under Equity Compensation Plans”, and that information is incorporated herein by reference.

16

Performance Graph

Set forth below is a line graph comparing the cumulative total shareholder return on our common stock with the cumulative total return of the NASDAQ Stock Market (U.S. & Foreign) Index and the NASDAQ Electronic Components Index in fiscal 2017.

6/30/2012

6/29/2013

6/28/2014

6/27/2015

7/2/2016

7/1/2017

Key Tronic Corporation

100.00

125.61

130.22

129.37

89.68

86.04

NASDAQ Composite

100.00

117.69

155.50

177.19

173.36

221.11

NASDAQ Electronic Components

100.00

108.97

149.17

164.19

178.10

251.18

17

Item 6:

SELECTED FINANCIAL DATA

The following selected data is derived from our audited consolidated financial statements and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the consolidated financial statements and related notes, and other information included in this report.

Financial Highlights

(In thousands, except for Supplemental Data and Per Share Amounts)

Fiscal Year Ended

July 1, 2017

July 2, 2016

June 27, 2015 (3)

June 28, 2014(3)

June 29, 2013

Consolidated Statements of Operations Data:

Net sales

$

467,797

$

484,965

$

433,997

$

305,394

$

361,033

Gross profit

38,300

38,825

33,305

26,854

34,512

Gross margin percentage

8.2

%

8.0

%

7.7

%

8.8

%

9.6

%

Operating income

9,544

10,416

6,653

9,304

18,126

Operating margin percentage

2.0

%

2.1

%

1.5

%

3.0

%

5.0

%

Net income

5,617

6,533

4,304

7,613

12,583

Earnings per share – diluted

0.51

0.58

0.38

0.67

1.12

Consolidated Cash Flow Data:

Cash flows provided by operations

9,425

4,580

7,667

1,458

29,282

Capital expenditures

9,307

13,277

8,808

7,763

3,470

Consolidated Balance Sheet Data:

Net working capital (1)

100,440

97,349

98,318

71,049

73,827

Total assets

232,840

235,924

230,794

156,660

135,130

Long-term liabilities

38,520

46,232

43,237

848

3,030

Shareholders’ equity

116,567

105,582

100,768

103,645

94,160

Book value per share (2)

$

10.83

$

9.84

$

9.42

$

9.83

$

8.97

Supplemental Data:

Number of shares outstanding at year-end

10,759,680

10,725,349

10,706,136

10,546,750

10,502,188

Number of employees at year-end

5,038

4,947

4,866

3,343

2,584

Approximate square footage of operational facilities

1,760,000

1,828,000

1,892,000

1,139,000

1,011,000

(1)

Net working capital is defined as total current assets less total current liabilities. Net working capital measures the portion of current assets that are financed by long term funds and is an indicator of short term financial management.

(2)

Book value per share is defined as total shareholders’ equity divided by the number of shares outstanding at the end of the fiscal year.

(3)

Reflects the acquisition of Ayrshire on September 3, 2014 in fiscal year 2015 and Sabre on July 1, 2013 in fiscal year 2014.

18

Item 7:

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

KeyTronicEMS is a leader in electronic manufacturing services and solutions to original equipment manufacturers of a broad range of products. We provide engineering services, worldwide procurement and distribution, materials management, world-class manufacturing and assembly services, in-house testing, and unparalleled customer service. Our international production capability provides our customers with benefits of improved supply-chain management, reduced inventories, lower transportation costs, and reduced product fulfillment time. We continue to make investments in all of our operating facilities to give us the production capacity, capabilities and logistical advantages to continue to win new business. The following information should be read in conjunction with the consolidated financial statements included herein and with Item 1A, Risk Factors included as part of this filing.

Our mission is to provide our customers with superior manufacturing and engineering services at the lowest total cost for the highest quality products, and create long-term mutually beneficial business relationships by employing our “Trust, Commitment, Results” philosophy.

Executive Summary

During fiscal 2017, our revenue and margins were impacted by declining demand from some longstanding customers, which was not yet offset by the continued ramp in revenue from our new programs. While the EMS business is very competitive, we continued to win new business during the year, including two new programs involving gaming and seismic monitoring devices awarded in the fourth quarter, bringing the total number of significant program wins to nine for the fiscal year.

Net sales of $467.8 million for fiscal year 2017 decreased by 3.5 percent as compared to net sales of $485.0 million in fiscal year 2016. The decrease in net sales was primarily driven by a decrease in net sales from the former longstanding customer and closure of our Harrodsburg, Kentucky facility which has been discussed in prior quarters, partially offset by an increase in new program wins.

Throughout fiscal 2017, we made significant investments in improving our customer support organization and expanding our SMT, sheet metal and plastic molding capabilities in preparation for future growth. Moving into fiscal 2018, we continue to see a strong pipeline of potential new business and our new programs continue to ramp. We believe we’re well positioned to see growth in revenue and increasing profitability in the second half of the year

For the first quarter of fiscal year 2018, the Company expects to report revenue in the range of $110 million to $115 million. Future results will depend on actual levels of customers’ orders, the timing of the start-up of production of new product programs and the potential impact of the geopolitical uncertainty. We believe that we are well positioned in the EMS industry to continue expansion of our customer base and continue long-term growth.

Gross profit as a percent of net sales was 8.2 percent in fiscal year 2017 compared to 8.0 percent for the prior fiscal year. The increase in gross profit as a percentage of net sales was primarily related to a decrease in material related costs partially offset by an increase in certain overhead costs. The level of gross margin is impacted by product mix, timing of the startup of new programs, facility utilization, pricing within the electronics industry and material costs, which can fluctuate significantly from quarter to quarter and year to year.

Operating income as a percentage of net sales for fiscal year 2017 was 2.0 percent compared to 2.1 percent for fiscal year 2016. The decrease in operating income as a percentage of net sales was primarily due to an increase in selling, general and administrative expenses. This increase in SG&A expenses is primarily related to an increase in legal fees.

Net income for fiscal year 2017 was $5.6 million or $0.51 per diluted share, as compared to net income of $6.5 million or $0.58 per diluted share for fiscal year 2016. The decrease in net income for fiscal year 2017 as compared to fiscal year 2016 was primarily driven by the decrease in net revenue as described above.

19

We maintain a strong balance sheet with a current ratio of 2.3 and a debt to equity ratio of 0.37. Total cash provided by operating activities as defined on our cash flow statement was $9.4 million during fiscal year 2017. We maintain sufficient liquidity for our expected future operations. As of July 1, 2017, we had $18.3 million outstanding on our revolving line of credit with Wells Fargo Bank, N.A. As a result, $26.3 million remained available to borrow as of July 1, 2017. We believe cash flow from operations, our borrowing capacity, our accounts receivable sale program, and equipment financing should provide adequate capital for planned growth over the long term.

RESULTS OF OPERATIONS

Comparison of the Fiscal Year Ended July 1, 2017 with the Fiscal Year Ended July 2, 2016

The following table sets forth for the periods indicated certain items of the consolidated statements of income expressed as a percentage of net sales. The financial information and discussion below should be read in conjunction with the consolidated financial statements and notes contained in this Annual Report.

Fiscal Year Ended

July 1, 2017

% of

net sales

July 2, 2016

% of

net sales

$ change

% point

change

Net sales

$

467,797

100.0%

$

484,965

100.0%

$

(17,168

)

—

Cost of sales

429,497

91.8

446,140

92.0

(16,643

)

(0.2)

Gross profit

38,300

8.2

38,825

8.0

(525

)

0.2

Operating expenses:

Research, development and engineering

6,393

1.4

6,397

1.3

(4

)

0.1

Selling, general and administrative

22,363

4.8

22,012

4.5

351

0.3

Total operating expenses

28,756

6.2

28,409

5.8

347

0.4

Operating income

9,544

2.0

10,416

2.1

(872

)

(0.1)

Interest expense, net

2,288

0.4

2,265

0.5

23

(0.1)

Income before income taxes

7,256

1.6

8,151

1.7

(895

)

(0.1)

Income tax provision

1,639

0.4

1,618

0.3

21

0.1

Net income

$

5,617

1.2%

$

6,533

1.3%

$

(916

)

(0.1)

Effective income tax rate

22.6

%

19.9

%

Net Sales

The decrease in net sales of $17.2 million from prior year was primarily driven by a decrease in net sales from the former longstanding customer which has been discussed in prior quarters, partially offset by an increase in new program wins.

The following table shows the revenue by industry sectors as a percentage of revenue for fiscal years 2017 and 2016:

Fiscal Year Ended

July 1, 2017

July 2, 2016

Industrial

40%

39%

Consumer

35

31

Gaming

9

7

Communication

8

13

Printers

5

6

Computer and Peripheral

2

1

Transportation

1

3

Total

100%

100%

We provide services to customers in a number of industries and produce a variety of products for our customers in each industry. Key Tronic does not target any particular industry, but rather seeks to find programs that strategically fit our vertical manufacturing capabilities. As we continue to diversify our customer base and win new customers, we will continue to see a change in the industry concentrations of our revenue.

Sales to foreign locations represented 22.6 percent and 28.3 percent of our total net sales in fiscal years 2017 and 2016, respectively.

20

Cost of Sales

Total cost of sales as a percentage of net sales was 91.8 percent and 92.0 percent in fiscal years 2017 and 2016, respectively.

Total cost of materials as a percentage of net sales was approximately 61.7 percent and 63.9 percent in fiscal years 2017 and 2016, respectively. The change from year-to-year is primarily a result of improved pricing of certain raw materials as well as a more favorable product mix.

Production and support costs as a percentage of net sales were 30.1 percent and 28.1 percent in fiscal years 2017 and 2016, respectively. The increase in fiscal year 2017 is primarily related absorption increasing as a percentage of sales during the fiscal year.

We provide a reserve for obsolete and non-saleable inventories based on specific identification of inventory against current demand and recent usage. We also consider our customers' ability to pay for inventory whether or not there is a lead-time assurance agreement for a specific program. The amounts charged to expense for these inventories were approximately $0.5 million and $0.8 million in fiscal years 2017 and 2016, respectively.

We provide warranties on certain products we sell and estimate warranty costs based on historical experience and anticipated product returns. Warranty expense is related to workmanship claims on keyboards and EMS products. The amounts charged to expense are determined based on an estimate of warranty exposure. The net warranty expense was approximately $68,000 and $95,000 in fiscal years 2017 and 2016, respectively.

Gross Profit

Gross profit as a percentage of net sales was 8.2 percent and 8.0 percent in fiscal years 2017, and 2016, respectively. The 0.2 percentage point increase in gross profit as a percentage of net sales during fiscal year 2017 as compared to fiscal year 2016 is primarily related to a 1.7 percentage point decrease in material related costs partially offset by a 1.5 percentage point increase in certain overhead costs. This reflects an increase in gross margin percentage year-over-year as the unprofitable manufacturing facility was closed and trimming non-profitable programs.

Changes in gross profit margins reflect the impact of a number of factors that can vary from period to period, including product mix, start-up costs and efficiencies associated with new programs, product life cycles, sales volumes, capacity utilization of our resources, management of inventories, component pricing and shortages, end market demand for customers’ products, fluctuations in and timing of customer orders, and competition within the EMS industry. These and other factors can cause variations in operating results. There can be no assurance that gross margins will not decrease in future periods.

We took early pay discounts to suppliers that totaled approximately $1.9 million and $1.9 million in fiscal years 2017 and 2016, respectively. Early pay discounts will fluctuate based on our liquidity and changes in the discounts and terms offered by our suppliers.

Research, Development and Engineering

Research, development and engineering expenses (RD&E) consists principally of employee related costs, third party development costs, program materials, depreciation and allocated information technology and facilities costs. Total RD&E expenses were $6.4 million in fiscal years 2017 and 2016. Total RD&E expenses as a percent of net sales were 1.4 percent and 1.3 percent in fiscal years 2017 and 2016, respectively.

Selling, General and Administrative

Selling, general and administrative expenses (SG&A) consist principally of salaries and benefits, advertising and marketing programs, sales commissions, travel expenses, provision for doubtful accounts, facilities costs, and professional services. Total SG&A expenses were $22.4 million and $22.0 million in fiscal years 2017 and 2016, respectively. Total SG&A expenses as a percent of net sales were 4.8 percent and 4.5 percent in fiscal years 2017 and 2016, respectively. This 0.3 percentage point increase in SG&A as a percentage of net sales is primarily related to an increase in legal fees.

Interest Expense

We had net interest expense of $2.3 million in both fiscal years 2017 and 2016.

Income Tax Provision

We had an income tax expense of approximately $1.6 million during both fiscal years 2017 and 2016. The income tax expense recognized during both fiscal years 2017 and 2016, was primarily a function of U.S., federal, state and foreign taxes recognized at the statutory rates offset by the net benefit associated with federal research and development tax credits and changes in potential foreign tax credits.

21

We continually review our requirements for liquidity domestically to fund current operations, revenue growth and to look for potential future acquisitions. We anticipate repatriating a portion of our unremitted foreign earnings. The estimated taxes and associated foreign tax credits are included in the income tax calculation. For further information on taxes please review footnote 6 of the “Notes to Consolidated Financial Statements.”

International Subsidiaries

We offer customers a complete global manufacturing solution. Our facilities provide our customers the opportunity to have their products manufactured in the facility that best serves specific cost, product manufacturing and distribution needs. The locations of active foreign subsidiaries are as follows:

•

Key Tronic Juarez, SA de CV owns five facilities and leases two facilities in Juarez, Mexico. These facilities include an SMT facility, an assembly and molding facility, a sheet metal fabrication facility, and assembly and storage facilities. This subsidiary is primarily used to support our U.S. operations.

•

Key Tronic Computer Peripherals (Shanghai) Co., Ltd. leases two facilities with SMT, assembly, global purchasing and warehouse capabilities in Shanghai, China, which began operations in 1999. Its primary function is to provide EMS services for export.

Foreign sales (based on shipping instructions) from our worldwide operations, including domestic exports, were $105.9 million and $137.4 million in fiscal years 2017 and 2016, respectively. Products and manufacturing services provided by our subsidiary operations are often shipped to customers directly by the parent company.

RESULTS OF OPERATIONS

Comparison of the Fiscal Year Ended July 2, 2016 with the Fiscal Year Ended June 27, 2015

The following table sets forth for the periods indicated certain items of the consolidated statements of income expressed as a percentage of net sales. The financial information and discussion below should be read in conjunction with the consolidated financial statements and notes contained in this Annual Report.

Fiscal Year Ended

July 2, 2016

% of

net sales

June 27, 2015

% of

net sales

$ change

% point

change

Net sales

$

484,965

100.0%

$

433,997

100.0%

$

50,968

—

Cost of sales

446,140

92.0

400,692

92.3

45,448

(0.3)

Gross profit

38,825

8.0

33,305

7.7

5,520

0.3

Operating expenses:

Research, development and engineering

6,397

1.3

5,784

1.3

613

—

Selling, general and administrative

22,012

4.5

20,868

4.8

1,144

(0.3)

Total operating expenses

28,409

5.8

26,652

6.1

1,757

(0.3)

Operating income

10,416

2.1

6,653

1.5

3,763

0.6

Interest expense, net

2,265

0.5

1,353

0.3

912

0.2

Income before income taxes

8,151

1.7

5,300

1.2

2,851

0.5

Income tax provision

1,618

0.3

996

0.2

622

0.1

Net income

$

6,533

1.3%

$

4,304

1.0%

$

2,229

0.3

Effective income tax rate

19.9

%

18.8

%

Net Sales

The increase in net sales of $51.0 million from prior year was primarily driven by new program wins and to a lesser degree an increase in demand from current customers and the inclusion of Ayrshire for a full year of operations.

22

The following table shows the revenue by industry sectors as a percentage of revenue for fiscal years 2016 and 2015:

Fiscal Year Ended

July 2, 2016

June 27, 2015

Industrial

39%

34%

Consumer

31

28

Communication

13

16

Gaming

7

6

Printers

6

6

Transportation

3

8

Computer and Peripheral

1

2

Total

100%

100%

We provide services to customers in a number of industries and produce a variety of products for our customers in each industry. As we continue to diversify our customer base and win new customers we may continue to see a change in the industry concentrations of our revenue.

Sales to foreign locations represented 28.3 percent and 30.4 percent of our total net sales in fiscal years 2016 and 2015, respectively.

Cost of Sales

Total cost of sales as a percentage of net sales was 92.0 percent and 92.3 percent in fiscal years 2016 and 2015, respectively.

Total cost of materials as a percentage of net sales was approximately 63.9 percent and 64.6 percent in fiscal years 2016 and 2015, respectively. The change from year-to-year is primarily a result of improved pricing of certain raw materials as well as a more favorable product mix.

Production and support costs as a percentage of net sales were 28.1 percent and 27.7 percent in fiscal years 2016 and 2015, respectively. The increase in fiscal year 2016 is primarily related to inefficiencies associated with ramping production of new products that resulted in higher than expected operating expenses during the first half of fiscal year 2016.

We provide a reserve for obsolete and non-saleable inventories based on specific identification of inventory against current demand and recent usage. We also consider our customers' ability to pay for inventory whether or not there is a lead-time assurance agreement for a specific program. The amounts charged to expense for these inventories were approximately $0.8 million and $0.5 million in fiscal years 2016 and 2015, respectively.

We provide warranties on certain products we sell and estimate warranty costs based on historical experience and anticipated product returns. Warranty expense is related to workmanship claims on keyboards and EMS products. The amounts charged to expense are determined based on an estimate of warranty exposure. The net warranty expense was approximately $95,000 and $115,000 in fiscal years 2016 and 2015, respectively.

Gross Profit

Gross profit as a percentage of net sales was 8.0 percent and 7.7 percent in fiscal years 2016, and 2015, respectively. The 0.3 percentage point increase in gross profit as a percentage of net sales during fiscal year 2016 as compared to fiscal year 2015 is primarily related to a 1.2 percentage point decrease in material related costs partially offset by a 0.9 percentage point increase in certain overhead costs.

Changes in gross profit margins reflect the impact of a number of factors that can vary from period to period, including product mix, start-up costs and efficiencies associated with new programs, product life cycles, sales volumes, capacity utilization of our resources, management of inventories, component pricing and shortages, end market demand for customers’ products, fluctuations in and timing of customer orders, and competition within the EMS industry. These and other factors can cause variations in operating results. There can be no assurance that gross margins will not decrease in future periods.

We took early pay discounts to suppliers that totaled approximately $1.9 million and $1.5 million in fiscal years 2016 and 2015, respectively. Early pay discounts will fluctuate based on our liquidity and changes in the discounts and terms offered by our suppliers.

Research, Development and Engineering

Research, development and engineering expenses (RD&E) consists principally of employee related costs, third party development costs, program materials, depreciation and allocated information technology and facilities costs. Total RD&E expenses were $6.4 million and $5.8 million in fiscal years 2016 and 2015, respectively. Total RD&E expenses as a percent of net sales were 1.3 percent in fiscal years 2016 and 2015, respectively.

23

Selling, General and Administrative

Selling, general and administrative expenses (SG&A) consist principally of salaries and benefits, advertising and marketing programs, sales commissions, travel expenses, provision for doubtful accounts, facilities costs, and professional services. Total SG&A expenses were $22.0 million and $20.9 million in fiscal years 2016 and 2015, respectively. Total SG&A expenses as a percent of net sales were 4.5 percent and 4.8 percent in fiscal years 2016 and 2015, respectively. This 0.3 percentage point decrease in SG&A as a percentage of net sales is primarily related to approximately $0.8 million of non-recurring closing costs associated with the Ayrshire acquisition incurred during fiscal year 2015.

Interest Expense

We had net interest expense of $2.3 million and $1.4 million in fiscal years 2016 and 2015, respectively. The increase in interest expense is primarily related to the inclusion of a full year of the term loan balance outstanding and an increase in the average balance outstanding on our line of credit which was primarily used to fund growth in operations.

Income Tax Provision

We had an income tax expense of $1.6 million during fiscal year 2016 as compared to an income tax expense of $1.0 million in fiscal year 2015. The income tax expense recognized during both fiscal years 2016 and 2015, was primarily a function of U.S., federal, state and foreign taxes recognized at the statutory rates offset by the net benefit associated with federal research and development tax credits and changes in potential foreign tax credits.

We continually review our requirements for liquidity domestically to fund current operations, revenue growth and to look for potential future acquisitions. We anticipate repatriating a portion of our unremitted foreign earnings. The estimated taxes and associated foreign tax credits are included in the income tax calculation. For further information on taxes please review footnote 6 of the “Notes to Consolidated Financial Statements.”

Capital Resources and Liquidity

Operating Cash Flow

Net cash provided by operating activities for fiscal year 2017 was $9.4 million compared to net cash provided by operating activities of $4.6 million and $7.7 million in fiscal years 2016 and 2015, respectively.

The $9.4 million of net cash provided by operating activities during fiscal year 2017 is primarily related to $5.6 million of net income, $7.2 million of depreciation and amortization and a $4.9 million decrease in inventory, partially offset by a $3.5 million increase in accounts receivable and a $5.9 million decrease in accounts payable. The $4.6 million of net cash provided by operating activities during fiscal year 2016 was primarily due to $6.5 million of net income, $6.2 million of depreciation and amortization and an $11.1 million decrease in accounts receivable offset by a $16.2 million increase in inventory and a $2.6 million decrease in accounts payable. The $7.7 million of cash provided by operating activities during fiscal year 2015 was primarily due to $4.3 million of net income, $5.9 million of depreciation and amortization and an $18.0 million increase in accounts payable partially offset by a $14.7 million increase in inventory, a $2.1 million increase in accounts receivable and a $4.2 million increase in other assets.

Accounts receivable fluctuates based on the timing of shipments, terms offered and collections. In addition, accounts receivable will fluctuate based upon the amount of accounts receivable sold under our Trade Accounts Receivable Purchase Program. During fiscal years 2017, 2016 and 2015, we factored receivables of $86.5 million, $78.0 million and $12.1 million, respectively, from accounts receivable sold to financial institutions, which are not included on our Consolidated Balance Sheets. We purchase inventory based on customer forecasts and orders, and when those forecasts and orders change, the amount of inventory may also fluctuate. Accounts payable fluctuates with changes in inventory levels, volume of inventory purchases, negotiated supplier terms, and taking advantage of early pay discounts.

Investing Cash Flow

Cash flows used in investing activities were $8.5 million, $5.7 million, and $48.1 million in fiscal years 2017, 2016 and 2015, respectively. Our primary investing activity during fiscal year 2017 was purchasing equipment to support increased production levels for new programs. Our primary investing activities during fiscal year 2016 was the purchase of equipment to support increased production levels for new programs as well as the sale and leaseback of equipment. Our primary investing activities during fiscal year 2015 was the acquisitions of Ayrshire as discussed in further detail in footnote 14 of the “Notes to Consolidated Financial Statements.”

Operating and capital leases are often utilized when potential technical obsolescence and funding requirement advantages outweigh the benefits of equipment ownership. Capital expenditures and periodic lease payments are expected to be financed with internally generated funds and available borrowing capacities. During fiscal years 2017, 2016, and 2015, we received $0.6 million, $13.3 million, and $8.8 million of cash resulting from the sale and leaseback of equipment under operating leases, respectively.

24

Financing Cash Flow

Cash flows used in financing activities were $1.6 million in fiscal year 2017 as compared to cash flows provided by financing activities of $1.7 million and $35.0 million in fiscal years 2016 and 2015, respectively. Our primary financing activities during fiscal year 2017 was the funding of a $3.9 million equipment term loan, repayments on our term loans of $5.4 million as well as borrowings and repayments under our revolving line of credit facility. Our primary financing activities during fiscal year 2016 were repayments on our term loan of $5.0 million as well as borrowings and repayments under our revolving line of credit facility. Our primary financing activities during fiscal year 2015 were borrowings on our term loan of $31.3 million, net of repayments related to the Ayrshire acquisition, borrowings and repayments under our revolving line of credit facility and net repayments of $7.9 million related to the accounts receivable transfer program with Wells Fargo Bank N.A.

As of July 1, 2017, the Company had an outstanding balance on the line of credit of $18.3 million. We had availability to borrow an additional $26.3 million under the Wells Fargo line of credit and we were in compliance with our loan covenants. Our cash requirements are affected by the level of current operations and new EMS programs. We believe that projected cash from operations, funds available under the revolving credit facility and fixed asset financing will be sufficient to meet our working and fixed capital requirements for the foreseeable future.

As of July 1, 2017, we had approximately $0.4 million of cash held by foreign subsidiaries. If cash is to be repatriated in the future from these foreign subsidiaries, the Company could be subject to additional income taxes payable in the U.S. The total amount of U.S. taxes required to be paid for the amount of foreign subsidiary cash on hand as of July 1, 2017 would approximate $37,000. The Company also has approximately $28.4 million of foreign earnings that have not been repatriated to the U.S. Of that amount, the Company estimates that $13.4 million is to be repatriated in the future, requiring U.S. taxes of $1.4 million that is currently accrued in our deferred tax liabilities. The remaining $15.0 million is considered to be permanently reinvested in Mexico and China. If these amounts were required to be repatriated, we estimate it would create an additional $2.3 million in U.S. tax liability.

25

Contractual Obligations and Commitments

In the normal course of business, we enter into contracts which obligate us to make payments in the future. The table below sets forth our significant future obligations by fiscal year:

Payments Due by Fiscal Year (in thousands)

Total

2018

2019

2020

2021

2022

Thereafter

Term loans (1)

$

24,733

$

5,871

$

5,871

$

12,120

$

871

$

—

$

—

Wells Fargo Bank N.A. revolving loan (2)

$

18,335

$

—

$

—

$

18,335

$

—

$

—

$

—

Operating leases (3)

$

14,892

$

6,747

$

3,979

$

1,873

$

1,114

$

325

$

854

Purchase orders (4)

(1)

The terms of the Wells Fargo Bank N.A. term loans are discussed in the consolidated financial statements at Note 4, “Long-Term Debt.” Principal on the term loan is payable in equal quarterly installments of $1.25 million through June 15, 2019, with final installment of all remaining unpaid principal due on August 31, 2019. The equipment term loan is payable in equal quarterly payments of approximately $0.2 million which commenced on March 31, 2017 and will continue through the maturity of the equipment term loan on June 30, 2021.

(2)

The terms of the Wells Fargo Bank N.A. revolving loan are discussed in the consolidated financial statements at Note 4, “Long-Term Debt.” As of July 1, 2017, we were in compliance with our loan covenants. Breaching these covenants could have resulted in a material impact on our operations or financial condition and could impact our ability to borrow under this facility in the future.

(3)

We maintain vertically integrated manufacturing operations in the United States, Mexico and China. We lease some of our administrative and manufacturing facilities and equipment. A complete discussion of properties can be found in Part 1, Item 2 at “Properties.” Leases have proven to be an acceptable method for us to acquire new or replacement equipment and to maintain facilities with a minimum impact on our short term cash flows for operations. In addition, such operations are heavily dependent upon technically superior manufacturing equipment including molding machines in various tonnages, Surface Mount Technology (SMT) lines, sheet metal fabrication and stamping machines, clean rooms, and automated insertion, and test equipment for the various products we are capable of producing.

(4)

As of July 1, 2017, we had open purchase order commitments for materials and other supplies of approximately $28.9 million. Included in the open purchase orders are various blanket orders for annual requirements. Actual needs under these blanket purchase orders fluctuate with our manufacturing levels and as such cannot be broken out between fiscal years. In addition, we have contracts with many of our customers that minimize our exposure to losses for material purchased within lead-times necessary to meet customer forecasts. Purchase orders generally can be cancelled without penalty within specified ranges that are determined in negotiations with our suppliers. These agreements depend in part on the type of materials purchased as well as the circumstances surrounding any requested cancellations.

In addition to the cash requirements presented above, we have various other accruals which are not included in the table above. For example, we owe our suppliers approximately $53.1 million for accounts payable and shipments in transit at the end of the fiscal year. We generally pay our suppliers in a range from 30 to 120 days depending on terms offered. These payments are financed by operating cash flows and our revolving line of credit.

We believe that cash flows generated from operations, factoring, leasing facilities, and funds available under the revolving credit facility will satisfy cash requirements for a period in excess of 12 months and into the foreseeable future.

26

Critical Accounting Policies and Estimates

Preparation of our consolidated financial statements requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenues and expenses. Note 1 to our consolidated financial statements describes the significant accounting policies used in the preparation of our consolidated financial statements. Management believes the most complex and sensitive judgments, because of their significance to our consolidated financial statements, result primarily from the need to make estimates about effects of matters that are inherently uncertain. The most significant areas involving management judgments are described below. Actual results in these areas could differ from management’s estimates.

Revenue

Sales revenue from manufacturing is recognized upon shipment of the manufactured product per contractual terms. Upon shipment, title transfers and the customer assumes risks and rewards of ownership of the product. The price to the buyer is fixed or determinable and recoverability is reasonably assured. Unless specifically stated in contractual terms, there are no formal customer acceptance requirements or further obligations related to the manufacturing services; if any such requirements exist, then sales revenue is recognized at the time when such requirements are completed and such obligations are fulfilled. Revenue is recorded net of estimated returns of manufactured product based on management’s analysis of historical returns.

Revenues and associated costs from engineering design, development services and tooling, which are performed under contract of short term durations, are recognized only after the completed performance of the service.

Inactive, Obsolete, and Surplus Inventory Reserve

Inventories are stated at the lower of cost or net realizable value. Cost is determined principally using the first-in, first-out (FIFO) method. We reserve for inventories that we deem inactive, obsolete or surplus. This reserve is calculated based upon the demand for the products that we produce. Demand is determined by expected sales, customer purchase orders, or customer forecasts. If expected sales do not materialize, then we would have inventory in excess of our reserves and would have to charge the excess against future earnings. In the case where we have purchased material based upon a customer’s forecast or purchase orders, we are usually covered by lead-time assurance agreements or purchase orders with each customer. These contracts state that the financial liability for material purchased within agreed upon lead-time and based upon the customer’s forecasts, lies with the customer. If we purchase material outside the lead-time assurance agreement and the customer’s forecasts do not materialize or if we have no lead-time assurance agreement for a specific program, we would have the financial liability and may have to charge inactive, obsolete or surplus inventory against earnings. We also reserve for inventory related to specific customers covered by lead-time assurance agreements when those customers are experiencing financial difficulties or reimbursement is not reasonably assured.

Allowance for Doubtful Accounts

We value our accounts receivable net of an allowance for doubtful accounts. As of July 1, 2017 and July 2, 2016, the allowance for doubtful accounts was approximately $0.1 million, respectively. This allowance is based on estimates of the portion of accounts receivable that may not be collected in the future. The estimates used are based primarily on specific identification of potentially uncollectible accounts. Such accounts are identified using publicly available information in conjunction with evaluations of current payment activity. However, if any of our customers were to develop unexpected and immediate financial problems that would prevent payment of open invoices, we could incur additional and possibly material expenses that would negatively impact earnings.

Accrued Warranty

An accrual is made for expected warranty costs, with the related expense recognized in cost of goods sold. We review the adequacy of this accrual quarterly based on historical analysis and anticipated product returns and rework costs. Our warranty period for keyboards is generally longer than that for EMS products. We only warrant materials and workmanship on EMS products, and we do not warrant design defects for EMS customers.

Income Taxes

Income tax expense includes U.S. and international income taxes and the provision for U.S. taxes on undistributed earnings of foreign subsidiaries not deemed to be permanently invested. We do not record U.S. tax liabilities on undistributed earnings of international subsidiaries that are deemed to be permanently reinvested. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. The deferred income taxes are classified as long-term assets or liabilities. The most significant areas involving management judgments include deferred income tax assets and liabilities, uncertain tax positions, and research and development tax credits. Our estimates of the realization of the deferred tax assets related to our tax credits are based upon our estimates of future taxable income which may change.

27

Stock-Based Compensation

Stock-based compensation is accounted for according to Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 718, Compensation—Stock Compensation. ASC 718 requires us to expense the fair value of employee stock options, stock appreciation rights and other forms of stock-based compensation. Under the fair value recognition provisions of ASC 718, share-based compensation cost is estimated at the grant date based upon the fair value of the award and is recognized as expense ratably over the requisite service period of the award (generally the vesting period). Determining the appropriate fair value model and calculating the fair value of share-based awards requires judgment, including estimating the expected life of the share-based award, the expected stock price volatility over the expected life of the share-based award and forfeitures.

To determine the fair value of stock based awards on the date of grant we use the Black-Scholes option-pricing model. Inherent in this model are assumptions related to expected stock price volatility, option life, risk-free interest rate and dividend yield. The risk-free interest rate is a less-subjective assumption as it is based on factual data derived from public sources. We use a dividend yield of zero as we have never paid cash dividends and have no intention to pay cash dividends in the foreseeable future. The expected stock price volatility and option life assumptions require a greater level of judgment. Our expected stock-price volatility assumption is based upon the historical volatility of our stock which is obtained from public data sources. The expected life represents the weighted average period of time that share-based awards are expected to be outstanding, giving consideration to vesting schedules and historical exercise patterns. We determine the expected life assumption based upon the exercise and post-vesting behavior that has been exhibited historically, adjusted for specific factors that may influence future exercise patterns. If expected volatility or expected life were to increase, that would result in an increase in the fair value of our stock options which would result in higher compensation charges, while a decrease in volatility or the expected life would result in a lower fair value of our stock option awards resulting in lower compensation charges.

We estimate forfeitures for all of our awards based upon historical experience of stock-based pre-vesting forfeitures. We believe that our estimates are based upon outcomes that are reasonably likely to occur. If actual forfeitures are higher than our estimates it would result in lower compensation expense and to the extent the actual forfeitures are lower than our estimate we would record higher compensation expense.

Impairment of Long-Lived Assets

Long-lived assets, such as property, plant, and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated undiscounted future cash flows, an impairment charge would be recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset.

Derivatives and Hedging Activity

Derivatives are recognized on the balance sheet at their estimated fair value. On the date a derivative contract is entered into, the Company designates the derivative as a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (a “cash flow” hedge). The Company does not enter into derivatives for speculative purposes. Changes in the fair value of a derivative that qualifies as a cash flow hedge are recorded in “Accumulated Other Comprehensive Income,” until earnings are affected by the variability of cash flows. See Note 11 of the Company’s consolidated financial statements for additional information.

Long-Term Incentive Compensation Accrual

Long-term incentive compensation is recognized as expense ratably over the requisite service period of the award which is generally three years. The Board of Directors approve target performance measures for the three year period for each of the Company’s officers and non-employee Directors. Performance measures are based on a combination of sales growth targets and return on invested capital targets. No cash awards will be made to participants if actual Company performance does not exceed the minimum target performance measures. The calculation used to determine the necessary accrual uses a combination of actual results and projected results. We believe that our estimates are based upon outcomes that are reasonably likely to occur. These estimates and assumptions are based on historical results as well as future expectations. Actual results could vary from our estimates and assumptions.

28

Impairment of Goodwill

In accordance with ASC 350, Goodwill and Other Intangible Assets, goodwill is not amortized but is required to be reviewed for impairment at least annually or when events or circumstances indicate that carrying value may exceed fair value. The Company is permitted the option to first assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the fair value of any reporting unit is less than its corresponding carrying value. If, after assessing the totality of events and circumstances, the Company concludes that it is not more likely than not that the fair value of any reporting unit is less than its corresponding carrying value then the Company is not required to take further action. However, if the Company concludes otherwise, then it is required to perform a quantitative impairment test, including computing the fair value of the reporting unit and comparing that value to its carrying value. The Company utilizes a weighting of the income approach and a market approach in the impairment test. We also consider valuation factors including the Company's market capitalization, future discounted cash flows and an estimated control premium based upon a review of comparable market transactions. Our consideration of discounted future cashflows included assumptions regarding growth rates and margins based on our historical trends. In addition, we applied a market discount rate calculated based upon an analysis of companies similar in size. If our future cash flows do not meet our projections or there is an event that impacts our market capitalization, the assumptions used in our goodwill analysis could be negatively impacted. The estimated fair value of the reporting unit exceeded the carrying value by approximately 20%. We will continue to monitor our market capitalization and impairment indicators.

If the fair value is less than its carrying value, a second step of the test is required to determine if recorded goodwill is impaired. In the event that goodwill is impaired, an impairment charge to earnings would become necessary. The Company also has the option to bypass the qualitative assessment for goodwill in any period and proceed directly to performing the quantitative impairment test.

Business Combinations

The Company recognizes the assets acquired and liabilities assumed in business combinations on the basis of their fair values at the date of acquisition. We assess the fair value of assets, including intangible assets, using a variety of methods and each asset is measured at fair value from the perspective of a market participant. The method used to estimate the fair values of intangible assets incorporates significant assumptions regarding the estimates a market participant would make in order to evaluate an asset, including a market participant’s use of the asset and the appropriate discount rates for a market participant. Assets recorded from the perspective of a market participant that are determined to not have economic use for us are expensed immediately. Any excess purchase price over the fair value of the net tangible and intangible assets acquired is allocated to goodwill. Transaction costs and restructuring costs associated with a business combination are expensed as incurred.

New and Future Accounting Pronouncements

See Note 1 to our consolidated financial statements.

Item 7A:

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

We are subject to the risk of fluctuating interest rates in the normal course of business. Our major market risk relates to our secured debt. Our revolving credit facility and term loan are secured by substantially all of our assets. The interest rates applicable to our revolving credit facility and term loans fluctuate with the Wells Fargo Bank N.A. prime rate and LIBOR rates. There was outstanding $18.3 million in borrowings under our revolving credit facility and $24.6 million outstanding on our term loans as of July 1, 2017. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources and Liquidity” and Note 4 – “Long-Term Debt” to the Consolidated Financial Statements for additional information regarding our revolving credit facility and term loan.

Our only material interest rate risk is associated with our revolving credit facility and term loans. During the second quarter of fiscal year 2015, we entered into an interest rate swap contract with a notional amount of $25.0 million related to the borrowings outstanding under the term loan and revolving credit facility. As of July 1, 2017, the remaining notional amount of the interest rate swap contract was $14.5 million. Through the use of the interest rate swap, as described above, we fixed the basis on which we pay interest, thus eliminating much of our interest rate risk. See Note 11 – “Derivative Financial Instruments” to the Consolidated Financial Statements for additional information regarding our derivative instruments.

29

Foreign Currency Exchange Risk

A significant portion of our operations are in foreign locations. As a result, transactions occur in currencies other than the U.S. dollar. Exchange rate fluctuations among other currencies used by us would directly or indirectly affect our financial results. We currently use Mexican peso forward contracts to hedge foreign currency fluctuations for a portion of our Mexican peso denominated expenses. There was $55.7 million of foreign currency forward contracts outstanding as of July 1, 2017. The fair value of these contracts was approximately $(4.1) million. See Note 11 – “Derivative Financial Instruments” to the Consolidated Financial Statements for additional information regarding our derivative instruments.

30

Item 8:

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders

Key Tronic Corporation

Spokane Valley, Washington

We have audited the accompanying consolidated balance sheets of Key Tronic Corporation as of July 1, 2017 and July 2, 2016 and the related consolidated statements of income, comprehensive income (loss), shareholders' equity, and cash flows for each of the three years in the period ended July 1, 2017. In connection with our audits of the financial statements, we have also audited the financial statement schedule listed in the accompanying index. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Key Tronic Corporation at July 1, 2017 and July 2, 2016, and the results of its operations and its cash flows for each of the three years in the period ended July 1, 2017, in conformity with accounting principles generally accepted in the United States of America.

Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Key Tronic Corporation's internal control over financial reporting as of July 1, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated August 17, 2017 expressed an unqualified opinion thereon.

/s/ BDO USA, LLP

Spokane, Washington

September 8, 2017

31

KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands)

July 1, 2017

July 2, 2016

ASSETS

Current assets:

Cash and cash equivalents

$

373

$

1,018

Trade receivables, net of allowance for doubtful accounts of $84 and $135

Other comprehensive income (loss) for fiscal years 2017, 2016, and 2015 is reflected net of tax provision (benefit) of approximately $2.5 million, $(1.4) million and $(3.7) million, respectively.

See accompanying notes to consolidated financial statements.

34

KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

Fiscal Year Ended

July 1, 2017

July 2, 2016

June 27, 2015

Operating activities:

Net income

$

5,617

$

6,533

$

4,304

Adjustments to reconcile net income to cash provided by operating activities:

Depreciation and amortization

7,232

6,162

5,910

Amortization of deferred loan costs

17

—

—

Excess tax benefit from exercise of stock options

—

(402

)

(50

)

Provision for obsolete inventory

496

757

520

Provision for warranty

68

95

115

(Recovery of) provision for doubtful accounts

(10

)

38

97

Loss on disposal of assets

101

—

70

Share-based compensation expense

692

764

732

Deferred income taxes

(471

)

(1,313

)

(1,517

)

Changes in operating assets and liabilities, net of acquisition:

Trade receivables

(3,505

)

11,136

(2,080

)

Inventories

4,920

(16,169

)

(14,708

)

Other assets

636

1,739

(4,249

)

Accounts payable

(5,889

)

(2,561

)

17,999

Accrued compensation and vacation

434

104

(283

)

Other liabilities

(913

)

(2,303

)

807

Cash provided by operating activities

9,425

4,580

7,667

Investing activities:

Payment for acquisition, net of cash acquired

—

—

(47,964

)

Purchases of property and equipment

(9,307

)

(13,277

)

(8,808

)

Proceeds from sale of fixed assets

834

7,612

8,641

Cash used in investing activities

(8,473

)

(5,665

)

(48,131

)

Financing activities:

Payment of financing costs

(221

)

(113

)

(62

)

Proceeds from issuance of long term debt

3,919

—

35,000

Repayments of long term debt

(5,435

)

(5,000

)

(3,750

)

Borrowings under revolving credit agreement

161,240

197,568

137,987

Repayments of revolving credit agreement

(160,978

)

(191,126

)

(126,356

)

Proceeds from accounts receivable transfer agreement

—

—

1,116

Payments towards accounts receivable transfer agreement

—

—

(8,969

)

Excess tax benefit from exercise of stock options

—

402

50

Proceeds from exercise of stock options

—

—

17

Tax withholding from exercise of share-based compensation

(122

)

—

—

Cash (used in) provided by financing activities

(1,597

)

1,731

35,033

Net (decrease) increase in cash and cash equivalents

(645

)

646

(5,431

)

Cash and cash equivalents, beginning of period

1,018

372

5,803

Cash and cash equivalents, end of period

$

373

$

1,018

$

372

Supplemental cash flow information:

Interest payments

$

2,238

$

2,308

$

1,221

Income tax payments, net of refunds

$

1,799

$

813

$

3,274

See accompanying notes to consolidated financial statements.

35

KEY TRONIC CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(In thousands)

Shares

Common

Stock

Retained

Earnings

Accumulated

Other

Comprehensive

Income (Loss)

Total

Shareholders’

Equity

Balances, June 28, 2014

10,547

$

44,151

$

57,091

$

2,403

$

103,645

Net income

—

—

4,304

—

4,304

Unrealized loss on hedging instruments, net

—

—

—

(7,166

)

(7,166

)

Exercise of stock options

5

17

—

—

17

Exercise of stock appreciation rights

223

—

—

—

—

Shares withheld for taxes

(69

)

(814

)

—

—

(814

)

Share-based compensation

—

732

—

—

732

Excess tax benefit from share-based compensation

—

50

—

—

50

Balances, June 27, 2015

10,706

$

44,136

$

61,395

$

(4,763

)

$

100,768

Net income

—

—

6,533

—

6,533

Unrealized loss on hedging instruments, net

—

—

—

(2,810

)

(2,810

)

Exercise of stock appreciation rights

28

—

—

—

—

Shares withheld for taxes

(9

)

(75

)

—

—

(75

)

Share-based compensation

—

764

—

—

764

Excess tax benefit from share-based compensation

—

402

—

—

402

Balances, July 2, 2016

10,725

$

45,227

$

67,928

$

(7,573

)

$

105,582

Net income

—

—

5,617

—

5,617

Unrealized gain on hedging instruments, net

—

—

—

4,798

4,798

Exercise of stock appreciation rights

49

—

—

—

—

Shares withheld for taxes

(14

)

(122

)

—

—

(122

)

Share-based compensation

—

692

—

—

692

Balances, July 1, 2017

10,760

$

45,797

$

73,545

$

(2,775

)

$

116,567

See accompanying notes to consolidated financial statements.

36

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SIGNIFICANT ACCOUNTING POLICIES

Business

Key Tronic Corporation and subsidiaries (the Company) is engaged in electronic manufacturing services (EMS) for original equipment manufacturers (OEMs) and also manufactures keyboards and other input devices. The Company’s headquarters are located in Spokane Valley, Washington with manufacturing operations in Oakdale, Minnesota; Fayetteville, Arkansas; Corinth, Mississippi; and foreign manufacturing operations in Juarez, Mexico; and Shanghai, China.

Principles of Consolidation

The consolidated financial statements include the Company and its wholly owned subsidiaries in the United States, Mexico and China. Intercompany balances and transactions have been eliminated during consolidation.

Reclassifications

Certain prior period reclassifications were made to conform with the current period presentation. These reclassifications had no effect on reported income, comprehensive income (loss), cash flows, total assets, or shareholders' equity as previously reported.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates include the allowance for doubtful receivables, the provision for obsolete and non-saleable inventories, deferred tax assets and liabilities, uncertain tax positions, valuation of goodwill, impairment of long-lived assets, medical self-funded insurance liability, long-term incentive compensation accrual, the provision for warranty costs, the fair value of stock appreciation rights granted under the Company’s share-based compensation plan and purchase price allocation of acquired businesses. Due to uncertainties with respect to the assumptions and estimates, actual results could differ from those estimates.

Cash and Cash Equivalents

The Company considers investments with an original maturity of three months or less to be cash equivalents. Cash equivalents are carried at cost, which approximates fair value. The Company may have cash and cash equivalents at financial institutions that are in excess of federally insured limits from time to time.

Allowance for Doubtful Accounts

The Company evaluates the collectability of accounts receivable and records an allowance for doubtful accounts, which reduces the receivables to an amount that management reasonably estimates will be collected. A specific allowance is recorded against receivables considered to be impaired based on the Company’s knowledge of the financial condition of the customer. In determining the amount of the allowance, the Company considers several factors including the aging of the receivables, the current business environment and historical experience. After all attempts to collect a receivable have failed, the receivable is written off against the allowance.

Inventories

Inventories are stated at the lower of cost or net realizable value. Cost is determined principally using the first-in, first-out (FIFO) method. Customer orders are based upon forecasted quantities of product manufactured for shipment over defined periods. Raw material inventories are purchased to fulfill these customer requirements. Within these arrangements, customer demands for products frequently change, sometimes creating excess and obsolete inventories. The Company regularly reviews raw material inventories by customer for both excess and obsolete quantities. Wherever possible, the Company attempts to recover its full cost of excess and obsolete inventories from customers or, in some cases, through other markets. When it is determined that the Company’s carrying cost of such excess and obsolete inventories cannot be recovered in full, a charge is taken against income for the difference between the carrying cost and the estimated realizable amount. We also reserve for inventory related to specific customers covered by lead-time assurance agreements when those customers are experiencing financial difficulties or reimbursement is not reasonably assured.

Property, Plant and Equipment

Property, plant and equipment are carried at cost and depreciated using straight-line methods over the expected useful lives of the assets. Repairs and maintenance costs are expensed as incurred.

37

Business Combinations

The Company recognizes the assets acquired and liabilities assumed in business combinations on the basis of their fair values at the date of acquisition. We assess the fair value of assets, including intangible assets, using a variety of methods and each asset is measured at fair value from the perspective of a market participant. The method used to estimate the fair values of intangible assets incorporates significant assumptions regarding the estimates a market participant would make in order to evaluate an asset, including a market participant’s use of the asset and the appropriate discount rates for a market participant. Assets recorded from the perspective of a market participant that are determined to not have economic use for us are expensed immediately. Any excess purchase price over the fair value of the net tangible and intangible assets acquired is allocated to goodwill. Transaction costs and restructuring costs associated with a business combination are expensed as incurred.

Impairment of Goodwill

The Company records intangible assets that are acquired individually or with a group of other assets in the financial statements at acquisition. In accordance with ASC 350, Goodwill and Other Intangible Assets, goodwill is not amortized but is required to be reviewed for impairment at least annually or when events or circumstances indicate that carrying value may exceed fair value. The Company tests goodwill by first performing a qualitative analysis (“Step 0”) to determine if it is more likely than not that the fair value of the reporting unit is greater than its carrying value. If the Company determines that it is not more likely than not that the fair value of the reporting unit is greater than its carrying value, the Company calculates the fair value of the reporting unit and compares the fair value of the reporting unit to its carrying value (“Step 1”). If the carrying value of the reporting unit exceeds the fair value, goodwill is potentially impaired and the second step (“Step 2”) of the impairment test must be performed. In the second step, the Company compares the implied fair value of the goodwill, as defined by ASC 350, to the carrying amount to determine the impairment loss, if any.

The Company performed its annual qualitative Step 0 analysis as of April 2, 2017 and determined a Step 1 analysis was necessary due to market conditions. Based on the results of the Step 1 analysis, the Company concluded that the fair value of the reporting unit was greater than the carrying value of the reporting unit based on a methodology that utilized both an income approach and a market approach. We considered valuation factors including the Company's market capitalization, future discounted cash flows and an estimated control premium based upon a review of comparable market transactions. Our consideration of discounted future cash included assumptions regarding growth rates and margins based on our historical trends. In addition, we applied a market discount rate calculated based upon an analysis of companies similar in size. The estimated fair value of the reporting unit exceeded the carrying value by approximately 20%. We will continue to monitor our market capitalization and impairment indicators.

Impairment of Long-lived Assets

The Company, using its best estimates based on reasonable and supportable assumptions and projections, reviews assets for impairment whenever events or changes in circumstances have indicated that the carrying amount of its assets might not be recoverable. Impaired assets are reported at the lower of cost or fair value.

Accrued Warranty

An accrual is made for expected warranty costs, with the related expense recognized in cost of goods sold. Management reviews the adequacy of this accrual quarterly based on historical analyses and anticipated product returns.

Self-funded Insurance

The Company self-funds its domestic employee health plans. The Company contracts with a separate administrative service company to supervise and administer the programs and act as its representative. The Company reduces its risk under this self-funded platform by purchasing stop-loss insurance coverage for high dollar individual claims. In addition, if the aggregate annual claims amount to more than 125 percent of expected claims for the plan year this insurance will also pay those claims amounts exceeding that level.

The Company estimates its exposure for claims incurred but not paid at the end of each reporting period and uses historical claims data supplied by the Company’s broker to estimate its self-funded insurance liability. This liability is subject to a total limitation that varies based on employee enrollment and factors that are established at each annual contract renewal. Actual claims experience may differ from the Company’s estimates. Costs related to the administration of the plan and related claims are expensed as incurred.

38

Revenue Recognition

Sales revenue from manufacturing is recognized upon shipment of the manufactured product per contractual terms. Upon shipment, title transfers and the customer assumes risks and rewards of ownership of the product. The price to the buyer is fixed or determinable and recoverability is reasonably assured. Unless specifically stated in contractual terms, there are no formal customer acceptance requirements or further obligations related to the manufacturing services; if any such requirements exist, then sales revenue is recognized at the time when such requirements are completed and such obligations are fulfilled. Revenue is recorded net of estimated returns of manufactured product based on management’s analysis of historical returns.

Revenues and associated costs from engineering design, development services and tooling, which are performed under contract of short term durations, are recognized only after the completed performance of the service. Revenue from engineering design, development services and tooling represented approximately 2.1 percent, 1.7 percent and 2.5 percent of total revenue in fiscal years 2017, 2016, and 2015, respectively.

Shipping and Handling Fees

The Company classifies costs associated with shipping and handling fees as a component of cost of goods sold. Customer billings related to shipping and handling fees are reported as revenue.

Research, Development and Engineering

Research, development and engineering expenses include unreimbursed EMS costs as well as design and engineering costs associated with the production of EMS programs. Research, development and engineering costs are expensed as incurred.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences and benefits attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis, as well as operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities for a change in tax rates is recognized in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount that is more likely than not to be realized.

We utilize a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments based on new assessments and changes in estimates and which may not accurately forecast actual outcomes. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax provision. To date, we have not incurred charges for interest or penalties in relation to the underpayment of income taxes. The tax years 1997 through the present remain open to examination by the major U.S. taxing jurisdictions to which we are subject. Refer to Note 6 for further discussions.

Derivative Instruments and Hedging Activities

The Company has entered into foreign currency forward contracts and an interest rate swap which are accounted for as cash flow hedges in accordance with ASC 815, Derivatives and Hedging. The effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income (AOCI) and is reclassified into earnings in the same period in which the underlying hedged transaction affects earnings. The derivative’s effectiveness represents the change in fair value of the hedge that offsets the change in fair value of the hedged item.

The Company uses derivatives to manage the variability of foreign currency fluctuations of expenses in our Mexico facilities and interest rate risk associated with certain borrowings under the Company’s debt arrangement. The foreign currency forward contracts and interest rate swaps have terms that are matched to the underlying transactions being hedged. As a result, these transactions fully offset the hedged risk and no ineffectiveness has been recorded.

The Company’s foreign currency forward contracts and interest rate swaps potentially expose the Company to credit risk to the extent the counterparties may be unable to meet the terms of the agreement. The Company minimizes such risk by seeking high quality counterparties. The Company’s counterparties to the foreign currency forward contracts and interest rate swaps are major banking institutions. These institutions do not require collateral for the contracts, and the Company believes that the risk of the counterparties failing to meet their contractual obligations is remote. The Company does not enter into derivative instruments for trading or speculative purposes.

39

Earnings Per Common Share

Basic earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is computed by dividing net income by the combination of other potentially dilutive weighted average common shares and the weighted average number of common shares outstanding during the period using the treasury stock method. The computation assumes the proceeds from the exercise of stock options were used to repurchase common shares at the average market price during the period. The computation of diluted earnings per common share does not assume conversion, exercise, or contingent issuance of common stock equivalent shares that would have an anti-dilutive effect on earnings per share.

Foreign Currency Transactions

The functional currency of the Company’s subsidiaries in Mexico and China is the U.S. dollar. Realized foreign currency transaction gains and losses for local currency denominated assets and liabilities are included in cost of goods sold.

Fair Value of Financial Instruments

The carrying values of cash and cash equivalents, accounts receivable and current liabilities reflected on the balance sheets at July 1, 2017 and July 2, 2016, reasonably approximate their fair value. The Company had an outstanding balance on the line of credit of $18.3 million as of July 1, 2017 and $18.1 million as of July 2, 2016, with a carrying value that reasonably approximates the fair value. The Company had an outstanding balance on the term loan of $21.3 million as of July 1, 2017 and $26.3 million as of July 2, 2016, with a carrying value that reasonably approximates the fair value. The equipment term loan is estimated to be $3.5 million as of July 1, 2017, with a carrying value that reasonably approximates the fair value. As of July 2, 2016, the Company did not have a balance under the equipment term loan.

Share-based Compensation

The Company’s incentive plan may provide for equity and liability awards to employees in the form of stock options, stock appreciation rights, restricted stock, restricted stock units, stock awards, stock units, performance shares, performance units, and other stock-based or cash-based awards. Compensation cost is recognized on a straight-line basis over the requisite employee service period, which is generally the vesting period, and is included in cost of goods sold, research, development and engineering, and selling, general, and administrative expenses. Share-based compensation is recognized only for those awards that are expected to vest, with forfeitures estimated at the date of grant based on historical experience and future expectations.

Restructuring

Periodically the Company may consolidate excess facilities in order to maximize efficiencies and reduce its costs. In connection with these activities, we recognize restructuring charges for employee termination costs, exit costs and long-lived asset impairment when applicable.

The recognition of these restructuring charges require that we make certain judgments and estimates regarding the nature, timing and amount of costs associated with the planned exit activity. To the extent our actual results differ from our estimates and assumptions, we may be required to revise the estimates of future liabilities, requiring the recognition of additional restructuring charges or the reduction of liabilities already recognized. Such changes to previously estimated amounts may be material to the consolidated financial statements. At the end of each reporting period, we evaluate the remaining accrued balances to ensure that no excess accruals are retained and the utilization of the provisions are for their intended purpose in accordance with developed exit plans.

40

Newly Adopted and Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2014-09 (ASU 2014-09), Revenue from Contracts with Customers. The guidance in this Update affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (for example, insurance contracts or lease contracts). The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under current guidance. This may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. Additionally, disclosures required for revenue recognition will include qualitative and quantitative information about contracts with customers, significant judgments and changes in judgments, and assets recognized from costs to obtain or fulfill a contract. Such disclosures are more extensive than what is required under existing GAAP. In August 2015, the FASB issued an amendment to defer the effective date of ASU 2014-09 for all entities by one year. This Update is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. The Company has assessed that the impact of the new guidance will result in a change of the Company's revenue recognition model for electronics manufacturing services from "point in time" upon physical delivery to an "over time" model and believes this transition may have a material impact on the Company's consolidated financial statements upon adoption primarily as it will recognize an increase in contract assets for unbilled receivables with a corresponding reduction in finished goods and work-in-progress inventory. The Company has commenced implementation in accordance with the planned effective date and such efforts are ongoing. Companies have the option of using either a full or modified retrospective approach in applying this standard. The Company has not yet concluded upon its selection of the transition method.

In July 2015, the FASB issued final guidance that simplifies the subsequent measurement of inventory for which cost is determined by methods other than last-in first-out (“LIFO”) and the retail inventory method. For inventory within the scope of the new guidance, entities will be required to compare the cost of inventory to only one measure, its net realizable value, and not the three measures required by the existing guidance. Net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. The new guidance should not change how entities initially measure the cost of inventory. The guidance will be effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. Early adoption is permitted. The Company adopted this guidance during the second quarter of fiscal year 2017 and it had no impact on our financial statements.

In February 2016, the FASB issued Accounting Standards Update 2016-02 (ASU 2016-02), Leases which supersedes ASC 840 Leases and creates a new topic, ASC 842 Leases. This update requires lessees to recognize a lease asset and a lease liability for all leases, including operating leases, with a term greater than 12 months on its balance sheet. The update also expands the required quantitative and qualitative disclosures surrounding leases. This update is effective for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years, with earlier adoption permitted. This update will be applied using a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. Upon initial evaluation, the Company believes the new guidance will have a material impact on its consolidated balance sheets when adopted. The Company is currently assessing the timing of adoption.

In March 2016, the FASB issued Accounting Standards Update 2016-09 (ASU 2016-09), Improvements to Employee Share-Based Payment Accounting. This update simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. This update is effective for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years, with earlier adoption permitted. The Company prospectively adopted this ASU during the first quarter of fiscal year 2017. As a result, excess tax benefits are recorded in income tax expense instead of a component of shareholders’ equity and excess tax benefits are no longer broken out on the consolidated statement of cash flows beginning in fiscal year 2017.

In August 2016, the FASB issued Accounting Standards Update 2016-15 (ASU 2016-15), Classification of Certain Cash Receipts and Cash Payments. This update provides guidance on how to record eight specific cash flow issues. This update is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted and a retrospective transition method to each period should be presented. The Company early adopted this guidance during the second quarter of fiscal year 2017 and it had no impact on our consolidated financial statements.

41

In January 2017, the FASB issued Accounting Standards Update 2017-04, Simplifying the Test for Goodwill Impairment. Under the new standard, goodwill impairment would be measured as the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying value of goodwill. This ASU eliminates existing guidance that requires an entity to determine goodwill impairment by calculating the implied fair value of goodwill by hypothetically assigning the fair value of a reporting unit to all of its assets and liabilities as if that reporting unit had been acquired in a business combination. This update is effective prospectively to impairment tests beginning June 28, 2020, with early adoption permitted. The Company would apply this guidance to applicable impairment tests after the adoption date. The Company is currently evaluating the effect of this update on its consolidated financial statements.

In May 2017, the FASB issued Accounting Standards Update 2017-09, Compensation - Stock Compensation. This update provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. This update is effective for fiscal years beginning after December 15, 2017. Early adoption is permitted. The Company is currently evaluating the effect of this update on its consolidated financial statements.

Fiscal Year

The Company operates on a 52/53 week fiscal year. Fiscal years end on the Saturday nearest June 30. As such, fiscal years 2017, 2016, and 2015, ended on July 1, 2017, July 2, 2016, and June 27, 2015, respectively. Fiscal year 2017 and 2015 were 52 week years whereas fiscal year 2016 was a 53 week year.

2. INVENTORIES

The components of inventories consist of the following (in thousands):

July 1, 2017

July 2, 2016

Finished goods

$

12,244

$

13,384

Work-in-process

20,596

18,988

Raw materials and supplies

68,750

74,634

$

101,590

$

107,006

3. PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment consists of the following:

Life

July 1, 2017

July 2, 2016

(in years)

(in thousands)

Land

—

$

2,940

$

2,940

Buildings and improvements

3 to 30

23,158

23,737

Equipment

1 to 10

57,848

53,095

Furniture and fixtures

3 to 5

3,512

2,924

87,458

82,696

Accumulated depreciation

(56,962

)

(54,771

)

$

30,496

$

27,925

42

4. LONG-TERM DEBT

On September 3, 2014, the Company entered into a five-year term loan in the amount of $35.0 million used to acquire all of the outstanding shares of CDR Manufacturing, Inc. (dba Ayrshire Electronics). The term loan requires quarterly payments of $1.25 million through June 15, 2019, with a final payment of the remaining outstanding balance on August 31, 2019. The Company had an outstanding balance of $21.3 million and $26.3 million under the term loan as of July 1, 2017 and July 2, 2016, respectively.

On August 6, 2015, the Company entered into a First Amendment to the amended and restated credit agreement extending the limit on our line of credit facility to $45.0 million as evidenced by the Second Replacement Revolving Note. The agreement specifies that the proceeds of the revolving line of credit be used primarily for working capital and general corporate purposes. The line of credit is secured by substantially all of the assets of the Company and matures on August 31, 2019 at which time all outstanding balances are payable. As of July 1, 2017, the Company had an outstanding balance under the credit facility of $18.3 million, $0.4 million in outstanding letters of credit and $26.3 million available for future borrowings. As of July 2, 2016, the Company had an outstanding balance under the credit facility of $18.1 million, $0.4 million in outstanding letters of credit and $26.5 million available for future borrowings.

On December 28, 2016, the Company entered into an equipment term loan agreement in the amount of $3.9 million in order to further invest in production equipment. The equipment term loan is collateralized by production equipment. Under this loan agreement, equal quarterly payments of approximately $0.2 million commenced on March 31, 2017 and will continue through the maturity of the equipment term loan on June 30, 2021. Amortization of the debt issuance costs is reported as interest expense on the consolidated income statement. As of July 1, 2017, the Company had an outstanding balance of $3.5 million. The Company did not have a balance as of July 2, 2016. The Company has available an additional $2.1 million which can be borrowed in the future under this agreement.

Borrowings under the revolving line of credit, term loan and equipment term loan bear interest at either a “Base Rate” or a “Fixed Rate,” as elected by the Company. The base rate is the higher of the Wells Fargo Bank prime rate, daily one month London Interbank Offered Rate (LIBOR) plus 1.5%, or the Federal Funds rate plus 1.5%. The fixed rate is LIBOR plus 1.75%, LIBOR plus 2.0% or LIBOR plus 2.25% depending on the level of the Company’s trailing four quarters Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). The interest rates on the outstanding debt as of July 1, 2017 range from 3.22% - 4.25% compared to 2.45% - 3.50% as of July 2, 2016.

Debt maturities as of July 1, 2017 for the next five years and thereafter are as follows (in thousands):

Fiscal Years Ending

Amount

2018

$

5,871

2019

5,871

2020

30,455

2021

871

2022

—

Total debt

$

43,068

Unamortized debt issuance costs

$

(119

)

Long-term debt, net of debt issuance costs

$

42,949

The Company must comply with certain financial covenants, including a cash flow leverage ratio, an asset coverage ratio and a fixed charge coverage ratio. The credit agreement requires the Company to maintain a minimum profit threshold, limits the maximum capital lease expenditures and restricts the Company from declaring or paying dividends in cash or stock without prior bank approval. The Company is in compliance with all financial covenants for all periods presented.

43

5. TRADE ACCOUNTS RECEIVABLE PURCHASE PROGRAMS

Sale Programs

The Company utilizes an Account Purchase Agreement with Wells Fargo Bank, N.A. ("WFB") which allows the Company to sell and assign to WFB and WFB may purchase from Company the accounts receivable of certain Company customers in a maximum aggregate amount outstanding of $20.0 million. This agreement may be cancelled at any time by either party. The Company also has an Account Purchase Agreement with Orbian Financial Services (“Orbian”). This agreement allows the Company to sell accounts receivable of certain customers to Orbian and the agreement may be cancelled at any time by either party.

Total accounts receivables sold during the twelve months ended July 1, 2017 and July 2, 2016 was approximately $86.5 million and $78.0 million, respectively. Accounts receivables sold and not yet collected was approximately $1.6 million and $1.7 million as of July 1, 2017 and July 2, 2016, respectively. The receivables that were sold were removed from the consolidated balance sheets and the cash received is reflected as cash provided by operating activities in the consolidated statements of cash flows.

6. INCOME TAXES

Income tax provision consists of the following:

Fiscal Year Ended

July 1, 2017

July 2, 2016

June 27, 2015

(in thousands)

Current income tax provision:

United States

$

1,231

$

1,014

$

1,701

Foreign

1,206

1,960

975

2,437

2,974

2,676

Deferred income tax benefit:

United States

(539

)

(1,285

)

(1,486

)

Foreign

(259

)

(71

)

(194

)

(798

)

(1,356

)

(1,680

)

Total income tax provision

$

1,639

$

1,618

$

996

The Company has gross tax credit carryforwards of approximately $8.2 million at July 1, 2017. Included in total tax credits carryforwards is approximately $7.4 million in research and development (R&D) tax credits.

Management also has reviewed its other deferred tax assets for purposes of determining whether or not a valuation allowance may be required. A valuation allowance against these deferred tax assets is required if it is more likely than not that some of the deferred tax assets will not be realized. Based on the Company’s profitability and estimated future repatriations from foreign subsidiaries, it has been determined that it is more likely than not that the deferred tax assets will be realized.

Management has reviewed and updated as necessary estimates of future repatriations of the undistributed earnings of its foreign subsidiaries. Based on this analysis, management expects to repatriate a portion of the foreign undistributed earnings based on increased sales growth driving additional U.S. capital requirements, cash requirements for potential acquisitions and to potentially implement certain tax strategies. No foreign earnings were repatriated from either foreign subsidiary during fiscal 2017 or 2016. The Company currently estimates that future repatriations from foreign subsidiaries will approximate $13.4 million. As such, as earnings are recognized in the United States, the Company would be subject to U.S. federal and state income taxes and potential withholding taxes are estimated to be approximately $6.6 million. Both the domestic tax and estimated withholding tax have been recorded as part of deferred taxes as of July 1, 2017. All other unremitted foreign earnings are expected to remain permanently reinvested for planned fixed asset purchases in foreign locations.

The Company has not provided for U.S. income taxes or foreign withholding taxes on approximately $15.0 million of earnings from foreign subsidiaries which are permanently reinvested outside the U.S. The unrecognized net tax provision, after netting U.S. federal and state income tax and any related foreign tax credits, would be approximately $2.3 million associated with these earnings.

During the second quarter of fiscal year 2017, the Company signed a unilateral advance pricing agreement (APA) with the Large Taxpayer Division of Mexico’s Servicio de Administración Tributaria (SAT) under an elective framework that has been agreed to by the U.S. and Mexican authorities. The APA is part of a larger program affecting hundreds of U.S. companies with maquiladora operations in Mexico. The general impact of the APA is to increase margins between the maquiladora and U.S. parent company, shifting profits to Mexico from the U.S.

44

As a result of the APA, the Company recognized an increased tax liability in Mexico of approximately $0.4 million related to the calendar years 2014-2016. However, the increased costs to the U.S. resulted in a reduced tax liability of approximately $0.4 million in the U.S. during fiscal year 2017. The overall net impact of the APA is therefore estimated to not be material to the Company’s consolidated financial results. The estimated increased liabilities in Mexico and related offsetting tax benefit in the U.S. were recorded during the second quarter of fiscal year 2017. The APA was finalized during the fourth quarter of fiscal year 2017.

Further, the resulting impact of the APA resulted in approximately $1.8 million of additional earnings being recognized in Mexico. The Company has reevaluated its repatriation assumptions and based on new customer growth in Mexico and related required capital expenditures, it is assumed that 50% of the additional $1.8 million in earnings will be permanently reinvested in Mexico.

The Company’s effective tax rate differs from the federal tax rate as follows:

Fiscal Year Ended

July 1, 2017

July 2, 2016

June 27, 2015

(in thousands)

Federal income tax provision at statutory rates

$

2,467

$

2,771

$

1,802

State income taxes, net of federal tax effect

175

250

133

Foreign tax rate differences

(156

)

(442

)

(80

)

Effect of income tax credits

(738

)

(1,254

)

(1,085

)

Effect of repatriation of foreign earnings, net

199

(161

)

(80

)

Other

(308

)

454

124

Transaction costs

—

—

182

Income tax provision

$

1,639

$

1,618

$

996

The domestic and foreign components of income before income taxes were:

Fiscal Year Ended

July 1, 2017

July 2, 2016

June 27, 2015

(in thousands)

Domestic

$

3,553

$

2,228

$

3,395

Foreign

3,703

5,923

1,905

Income before income taxes

$

7,256

$

8,151

$

5,300

45

Deferred income tax assets and liabilities consist of the following at:

July 1, 2017

July 2, 2016

(in thousands)

Deferred tax assets:

Tax credit carryforwards, net

$

4,164

$

4,056

Foreign subsidiaries - future tax credits

840

840

Inventory

840

508

Accruals

4,020

4,270

Mark-to-market adjustments

1,443

4,043

Other

28

86

Deferred income tax assets

$

11,335

$

13,803

Deferred tax liabilities:

Foreign subsidiaries – unremitted earnings

(2,288

)

(2,098

)

Fixed assets

(456

)

(1,025

)

Identifiable intangibles

(1,308

)

(1,613

)

Other

(302

)

(85

)

Deferred income tax liabilities

$

(4,354

)

$

(4,821

)

Net deferred income tax assets

$

6,981

$

8,982

Balance sheet caption reported in:

Long-term deferred income tax asset

$

6,981

$

8,982

Net deferred income tax asset

$

6,981

$

8,982

Uncertain Tax Positions

The Company has R&D tax credits that approximate $7.4 million that have 20 year carryforwards before expiring. The Company’s R&D tax credits expire in various fiscal years from 2021 to 2036. The Company also has alternative minimum tax credits, which do not expire, approximating $726,000.

As of July 1, 2017, the Company had unrecognized tax benefits of $3.9 million related to its gross R&D tax credits. The unrecognized tax benefits relate to certain R&D tax credits generated from 1999 to 2016.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:

Fiscal Year Ended

July 1, 2017

July 2, 2016

June 27, 2015

(in thousands)

Beginning Balance

$

3,760

$

3,446

$

3,072

Additions based on tax positions related to the current year

187

314

374

Ending Balance

$

3,947

$

3,760

$

3,446

The increase from the prior year is due to additional R&D credits that were recorded in 2017 as discussed above. Management does not anticipate any material changes to this amount during the next 12 months.

The Company recognizes interest accrued related to unrecognized tax benefits and penalties in its income tax provision. The Company has not recognized any interest or penalties in the fiscal years presented in these financial statements. The Company is subject to income tax in the U.S. federal jurisdiction, various state jurisdictions, Mexico and China. Certain years remain subject to examination but there are currently no ongoing exams in any taxing jurisdictions.

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7. EARNINGS PER SHARE

Basic earnings per share (EPS) is calculated by dividing net income (the numerator) by the weighted-average number of common shares outstanding (the denominator) during the period. Diluted EPS is computed by including both the weighted-average number of shares outstanding and any dilutive common share equivalents in the denominator. The following table presents a reconciliation of the denominator and the number of antidilutive common share awards that were not included in the diluted earnings per share calculation. These antidilutive securities occur when equity awards outstanding have an option price greater than the average market price for the period: